1. Chapter 14 Economic Growth and Rising Living Standards

2. Economic Growth and Rising Living Standards
Economist Thomas Malthus, writing in 1798, came to a striking conclusion
“Population, when unchecked, goes on doubling itself every twenty-five years, or increases in a geometrical ratio…The means of subsistence…could not possibly be made to increase faster than in an arithmetic ratio”
Prognosis was so pessimistic that it led Thomas Carlyle, one of Malthus’s contemporaries, to label economics “the dismal science”
History has proven Malthus wrong…at least in part
Economists today are optimistic about industrialized nations’ long-run material prospects
Achieving a higher rate of growth in long-run generally requires some sacrifice in short-run
Lieberman & Hall; Introduction to Economics, 2005

3. The Importance of Growth
Why should we be concerned about economic growth?
When output grows faster than population, GDP per capita will rise
When output grows more slowly than population, average standard of living will fall
Measuring standard of living by GDP per capita may seem limiting
Still, many aspects of our quality of life are counted in GDP such as
Food, housing, medical care, education, transportation services, and movies and video games
Economic growth is especially important in countries with income levels far below those of Europe, Japan, and United States
Other than emigration, economic growth is their only hope
Growth is a high priority in prosperous nations, too
When output per capita is growing, it’s at least possible for everyone to enjoy an increase in material well-being without having to cut back
Lieberman & Hall; Introduction to Economics, 2005

4. The Importance of Growth
When output per capita stagnates, material gains become a fight over a fixed pie
The more purchasing power my neighbor has, the less is left for me
In 1950s and 1960s, economic growth in wealthier nations seemed to be taking care of itself
All of that changed starting in 1970s
Economic growth became a national and international preoccupation
Over most of postwar period, output in more prosperous industrialized countries grew by 2 or 3% per year
Beginning in mid-1970s, all of these nations saw their growth rates slip
In late 1990s and early 2000s, only United States and United Kingdom returned to their previous high rates of growth
Other industrialized countries continued to grow more slowly than their historical averages
Seemingly small differences in growth rates matter a great deal
Lieberman & Hall; Introduction to Economics, 2005

5. What Makes Economies Grow?
Useful way to start thinking about long-run growth
Look at what determines our potential GDP in any given period
Real GDP depends on
Amount of output average worker can produce in an hour
Number of hours average worker spends at the job
Fraction of population that is working
Size of population
Amount of output the average worker produces in an hour is called labor productivity, or productivity
Measured by taking total output (real GDP) of economy over a period of time and dividing by total number of hours that everyone worked during the period to produce that output
Productivity = Output per hour = Total output ÷ Total hours worked
Lieberman & Hall; Introduction to Economics, 2005

6. What Makes Economies Grow?
Hours of the average worker can be found by dividing total hours worked over a period by total employment, number of people who worked during the period
Average Hours = Total hours worked ÷ Total Employment
Employment-population ratio (EPR) is found by dividing total employment by population
EPR = Total Employment ÷ Population
Lieberman & Hall; Introduction to Economics, 2005

7. What Makes Economies Grow?
Multiply these variables together
Total output = Total output ÷ Total hours worked x Total hours worked ÷ Total Employment x Total Employment ÷ Population x Population
Can write equation for total output as
Total output = Productivity x Average Hours x EPR x Population
Over long-run, when total output tracks closely with potential output, this will give us an equation for potential output
Lieberman & Hall; Introduction to Economics, 2005

8. What Makes Economies Grow?
Mathematics states that if two variables A and B are multiplied together
Percentage change in their product is approximately equal to sum of their percentage changes
% Δ (A x B) = % ΔA + % ΔB
Applying this rule to all four variables in right side of our equation, as well as to total output on left
Find that growth rate of output (% Δ Total Output) over any period of time is
% Δ Total Output = % Δ productivity + % Δ average hours + % Δ EPR + % Δ Population
Lieberman & Hall; Introduction to Economics, 2005

9. Economic Growth and Living Standards
Ultimately, growth in potential output does not by itself account for a rise in living standards
What matters for a rising standard of living is real GDP per capita
Total output = Productivity x Average Hours x EPR x Population
If we divide both sides by the population, we get
Total output ÷ Population = Productivity x Average Hours x EPR
In terms of percentage growth rates
% Δ Output per person = % Δ Productivity + % Δ Average hours + % Δ EPR
Notice that population drops out of the equation
Only way to raise living standards is to increase productivity, average hours, or labor force participation rate
Lieberman & Hall; Introduction to Economics, 2005

10. Economic Growth and Living Standards
If output per person grew due to growth in average work hours, it’s not clear that living standard would increase
In most developed countries, average hours are slowly decreasing, not increasing
So our last simplification is to ignore changes in average hours in growth equation
% Δ Output per person = % Δ productivity + % Δ EPR
To explain why U.S.—or any developed country—has enjoyed continual rises in living standards over long periods of time
Must look to growth in productivity and growth in employment-population ratio
Lieberman & Hall; Introduction to Economics, 2005

11. Growth in the Employment-Population Ratio (EPR)
With a constant population, any policy that increases total number of workers in economy will, by definition, increase employment-population ratio
Over past 50 years, as labor supply curve has shifted rightward, labor demand curve has shifted rightward as well
Why?
Changes have increased amount of output a worker can produce in any given period
So firms have wanted to hire more of them at any wage
Over past century, increases in labor demand have outpaced increases in labor supply
So that, on balance, average wage has risen and employment has increased
Lieberman & Hall; Introduction to Economics, 2005

12. Growth in the Employment-Population Ratio (EPR)
Impact of these changes on total employment has been dramatic
Currently, U.S. Bureau of Labor Statistics predicts employment growth of 1% per year until 2010—about the same as growth rate of population
Is there anything we can do to make it grow over the next several years, and thus increase our rate of economic growth?
Yes
But, keep in mind that these measures to increase employment would also have costs
Costs that Americans may or may not be willing to pay
Lieberman & Hall; Introduction to Economics, 2005

13. Figure 1: An Increase in Labor Supply
At point A, labor supply and demand determine an employment level of 100 million workers.
Real Hourly Wage
Millions of Workers A
$15 B
An increase in labor supply raises employment to 120 million (at point B) although with a lower wage rate. 12 LD
100
120
Lieberman & Hall; Introduction to Economics, 2005

14. Figure 2: An Increase in Labor Demand
Real Hourly Wage
Millions of Workers LS
If firms demand more labor, employment will increase–from 100 million to 120 million–while the wage rate rises. B
$17 15 A
100
120
Lieberman & Hall; Introduction to Economics, 2005

15. Figure 3: The U.S. Labor Market Over A Century
Real Hourly Wage
Millions of Workers W2 B W1 A L1 L2
Lieberman & Hall; Introduction to Economics, 2005

16. How To Increase Employment and the EPR
One set of policies to increase employment focuses on changing labor supply
An often-proposed example of this type of policy is a decrease in income tax rates
Tax cut would be just what was needed to get you to seek work
When we extend your reaction to population as a whole
Can see that a cut in income tax rate can convince more people to seek jobs at any given wage
Shifting labor supply curve rightward
Many American workers must pay combined federal, state, and local taxes of more than 40¢ out of each additional dollar they earn
This may be discouraging work effort in United States
In addition to tax rate changes, some economists have advocated changes in government transfer programs to speed growth in employment
Redesigning these programs might stimulate growth in labor supply
This reasoning was an important motive behind the sweeping reforms in U.S. welfare system in August 1996
Lieberman & Hall; Introduction to Economics, 2005

17. How To Increase Employment and the EPR
A cut in tax rates increases reward for working
While a cut in benefits to the needy increases hardship of not working
Either policy can cause a greater rightward shift in the economy’s labor supply curve than would otherwise occur
Which can raise the employment-population ratio and thereby raise output per person
Government policies can also affect labor demand curve
Government policies that help increase skills of the workforce or that subsidize employment more directly can cause a greater rightward shift in the labor demand curve than would otherwise occur,
Increasing employment and output
Lieberman & Hall; Introduction to Economics, 2005

18. How To Increase Employment and the EPR
Efforts to create growth in the employment-population ratio are controversial
In recent decades, those who prefer an activist government have favored policies to increase labor demand
Through government-sponsored training programs, more aid to college students, employment subsidies to firms, etc.
Those who prefer a more laissez-faire approach have generally favored policies to increase labor supply by decreasing government involvement
Lower taxes or a less generous social safety net
Lieberman & Hall; Introduction to Economics, 2005

19. Growth in Productivity
We eliminated variables that could not explain rising living standards over long-run
Ruled out population growth
Based on logic of equation for total output per person
Ruled out growth in average hours
Because of upper limit on this variable’s growth and high opportunity cost paid to raise hours per worker when most of labor force is already working full-time
Ruled out increases in the employment-population ratio
Only one variable remains
Productivity
Can we do anything to make productivity grow even faster?
Lieberman & Hall; Introduction to Economics, 2005

20. Growth in the Capital Stock
One key to productivity growth is growth in nation’s capital stock
Amount of capital available for average worker
With more capital a given number of workers can produce more output than before
Since same number of workers are working same number of hours, but producing more output than before, productivity rises
Growth in capital stock will increase productivity as long as it increases amount of capital per worker
If capital stock grows faster than labor force then capital per worker will rise
Labor productivity will increase along with it
But if capital stock grows more slowly than labor force, then capital per worker will fall
Labor productivity will fall as well
Lieberman & Hall; Introduction to Economics, 2005

21. Investment and the Capital Stock
An increase in capital stock plays a central role in economists’ thinking about growth
Contributes to a rise in labor productivity and helps to raise living standards
A stock variable measures a quantity at a moment in time
Capital stock is a measure of total plant and equipment in economy at any moment
Planned investment is a flow variable
Measures a process that takes place over a period of time
As long as investment is greater than depreciation, total stock of capital will rise
The greater the flow of investment, the faster will be the rise in capital stock
Lieberman & Hall; Introduction to Economics, 2005

22. The Loanable Funds Market
The loanable funds market is where business firms obtain funds for investment
Where do the funds that business firms demand come from?
Largely from household saving
Our picture of the loanable funds market would be very simple if this were all there was to it
But there is one more sector involved in this market:
The government
The government acts as a demander of funds when it runs a budget deficit
By law, it has no choice
It must borrow the money (demand loanable funds) by issuing U.S. government bonds
There is just one more piece of the puzzle to discuss before we analyze the loanable funds market more formally
Demanders of funds pay interest to suppliers of funds
Lieberman & Hall; Introduction to Economics, 2005

23. The Supply of Funds Curve
The quantity of funds supplied to the loanable funds market depends positively on the interest rate
This is why the saving, or supply of funds, curve slopes upward
Other things can affect saving besides the interest rate
In drawing the supply of funds curve, we hold each of these variables constant
Lieberman & Hall; Introduction to Economics, 2005

24. Figure 4: Supply of Household Loanable Funds
As the interest rate rises, saving or the quantity of loanable funds supplied increases.
Trillions of Dollars per Year
Interest Rate
Saving (S) or Supply of Funds B 5% A 3%
1.5
1.75
Lieberman & Hall; Introduction to Economics, 2005

25. The Demand For Funds Curve
Like saving, investment also depends on the interest rate
When the interest rate falls, investment spending and the business borrowing needed to finance it rise
The investment demand curve slopes downward
What about the government’s demand for funds?
Will it, too, be influenced by the interest rate?
The government sector’s deficit and, therefore, its demand for funds are independent of the interest rate
As the interest rate decreases, the quantity of funds demanded by business firms increases, while the quantity demanded by the government remains unchanged
Therefore, the total quantity of funds demanded rises
Lieberman & Hall; Introduction to Economics, 2005

26. Figure 5: Business Demand for Loanable Funds
As the interest rate falls, business firms demand more loanable funds for investment projects.
Trillions of Dollars per Year
Interest Rate A 5% B 3%
Planned Investment (IP) or Business Demand for Funds
1.0
1.5
Lieberman & Hall; Introduction to Economics, 2005

27. Figure 6: The Demand for Funds
Summing business demand for loanable funds at each interest rate . . .
. . . and the govern-ment's demand for loanable funds . . .
gives us the economy's total demand for loanable funds at each interest rate.
Trillions of Dollars per Year
Business Demand for Funds (IP)
Interest Rate 5% 3% A
1.0 B
1.5
Government Demand for Funds (G – T) A
0.75 B
Trillions of Dollars per Year
Total Demand for Funds [IP + (G – T)] A B
1.75
2.25
Trillions of Dollars per Year
Lieberman & Hall; Introduction to Economics, 2005

28. Equilibrium In The Loanable Funds Market
In the loanable funds market—like other markets—we can expect the price to adjust until quantity demanded and quantity supplied are equal
In this case, the price of funds—the interest rate—will rise or fall until the quantities of loanable funds supplied by households and the quantity demanded by firms and the government are equal
Lieberman & Hall; Introduction to Economics, 2005

29. Figure 7: Loanable Funds Market Equilibrium
Trillions of Dollars
Interest Rate
Total Supply of Funds (S) 5% E
Total Demand
for Funds
[IP + (G – T)]
1.75
Lieberman & Hall; Introduction to Economics, 2005

30. Targeting Businesses: Increasing the Incentive to Invest
One kind of policy to increase investment targets the business sector itself
With goal of increasing planned investment spending
Corporate profits tax
Tax on profits earned by corporations
Investment tax credit
A reduction in taxes for firms that invest in certain favored types of capital
Reducing business taxes or providing specific investment incentives can shift the investment curve rightward
Speeding growth in physical capital
Increasing growth rate of living standards
Lieberman & Hall; Introduction to Economics, 2005

31. Figure 8: An Increase In Investment Spending
Funds ($ Trillions)
Interest Rate
Supply of Funds (Saving) 5% B A C 3%
New Demand for Funds
Original Demand for Funds
1.5
1.75
2.25
Lieberman & Hall; Introduction to Economics, 2005

32. Targeting Households: Increasing the Incentive to Save
While firms purchase new capital, it is largely households that supply firms with funds, via personal saving
An increase in investment spending can originate in household sector, through an increase in desire to save
If households decide to save more of their incomes at any given interest rate
Supply of funds curve will shift rightward
What might cause households to increase their saving?
Greater uncertainty about economic future
Increase in life expectancy
Anticipation of an earlier retirement
Change in tastes toward big-ticket items
Change in attitude about saving
Any of these changes—if they occurred in many households simultaneously—would shift saving curve to the right
But government policy can increase household saving as well
One often-proposed idea is to decrease capital gains tax
Lieberman & Hall; Introduction to Economics, 2005

33. Targeting Households: Increasing the Incentive to Save
Another frequently proposed measure is to switch from current U.S. income tax
Taxes all income whether it is spent or saved
To a consumption tax
Would tax only the income that households spend
Another proposal to increase household saving is to restructure U.S. Social Security system
Provides support for retired workers who have contributed funds to system during their working years
Government can alter tax and transfer system to increase incentives for saving
If successful, these policies would
Make more funds available for investment
Speed growth in capital stock
Speed rise in living standards
Lieberman & Hall; Introduction to Economics, 2005

34. Figure 9: An Increase In Savings
Funds ($ Trillions)
Interest Rate
Original Supply of Funds
New Supply of Funds B 5% F C 3%
Investment Spending
1.75
2.25
2.5
Lieberman & Hall; Introduction to Economics, 2005

35. Figure 10: Deficit Reduction and Investment Spending
Funds ($ Trillions)
Interest Rate
Supply of Funds (Saving) E A 5% 3% B
Investment Spending
Investment Spending + Deficit
1.0
1.5
1.75
Lieberman & Hall; Introduction to Economics, 2005

36. Shrinking the Government’s Budget
A final pro-investment measure is directed at government sector itself
Link between government budget, interest rate, and investment spending is major reason why U.S. government, and governments around the world, try to reduce and, if possible, eliminate budget deficits
Shrinking deficit or rising surplus tends to reduce interest rates and increase investment
Speeding growth in capital stock
In 1990s, Congress set strict limits on growth of government spending
Budget deficit began shrinking
Lieberman & Hall; Introduction to Economics, 2005

37. Shrinking the Government’s Budget
When George W. Bush took office in 2001, direction of growth policy shifted away from preserving budget surpluses and toward lower tax rates
A second tax cut in 2003—amounting to $350 billion over 10 years—increased current and project deficits further
Tax cuts included some elements to increase investment spending
Such as a lower tax rate for capital gains and tax incentives for investment by small businesses
But the tax cuts
By raising current and future budget deficits would increase interest rates
Worked in opposition to the growth benefits of tax cut
Lieberman & Hall; Introduction to Economics, 2005

38. An Important Proviso About the Government Budget
A reduction in the budget deficit if it stimulates private investment—is not necessarily a pro-growth measure
Depends on how the budget changes
The answers can make a big difference to the impact on growth
Government investment in new capital and in maintenance of existing capital makes an important contribution to economic growth
Impact of deficit reduction on economic growth depends on which government programs are cut
Shrinking deficit by cutting government investment will not stimulate growth as much as would cutting other types of government spending
Lieberman & Hall; Introduction to Economics, 2005

39. Human Capital and Economic Growth
Skills and knowledge possessed by workers
An increase in human capital works like an increase in physical capital to raise productivity and increase average the standard of living
Human capital investments are made by business firms, by government, and by households
Human capital, unlike physical capital, cannot be separated from the person who provides it
Many pro-growth policies discussed earlier are also effective in promoting investment in human capital
Policies that increase employment or increase investment in physical capital
Lieberman & Hall; Introduction to Economics, 2005

40. Technological Change Another source of growth is technological change
Invention or discovery of new inputs, new outputs, or new methods of production
New technology affects economy in much the same way as does an increase in capital per worker
It raises labor productivity
Since it enables any given number of workers to produce more output
In many cases, new technology requires acquisition of physical and human capital before it can be used
In some instances, however, a new technology can be used without any additional equipment or training
As when a factory manager discovers a more efficient way to organize workers on the factory floor
The faster the rate of technological change
The greater the growth rate of productivity, and
The faster the rise in living standards
Lieberman & Hall; Introduction to Economics, 2005

41. Technological Change
Might seem that technological change is one of those things that just happens
But pace of technological change is not as haphazard as it seems
Rate of technological change in economy depends largely on firms’ total spending on R&D
Policies that increase R&D spending will increase pace of technological change
What can government do to increase spending on R&D?
Can increase its own direct support for R&D by carrying out more research in its own laboratories or increasing funding for universities and tax incentives to private research labs
Can enhance patent protection
Increases rewards for those who create new technology by giving them exclusive rights to use it or sell it
Encourages developers to spend more on R&D
R&D spending is in many ways just like other types of investment spending
Funds are drawn from the loanable funds market, and R&D programs require firms to buy something now (laboratories, the services of research scientists, materials to build prototypes) for uncertain prospect of future profits
Lieberman & Hall; Introduction to Economics, 2005

42. The Cost of Economic Growth
Why don’t all nations pursue these policies and push their rates of economic growth to the maximum?
Promoting economic growth involves unavoidable trade offs
Requires some groups, or nation as a whole, to give up something else that is valued
In order to decide how fast we want our economy to grow we must consider growth’s costs as well as benefits
One of the most important things you will learn in your introductory economics course is that there are no costless solutions to society’s problems
What are the costs of growth?
Lieberman & Hall; Introduction to Economics, 2005

43. Budgetary Costs Cutting income tax rate
Cutting taxes on capital gains or corporate profits
Cutting taxes on saving
Implementing any of these tax cuts would force the government to choose among three unpleasant alternatives
Increase some other tax to regain lost revenue, cut government spending, or permit budget deficit to rise
While properly targeted tax cuts can increase rate of economic growth
Will force us to either redistribute tax burden or cut government programs
Lieberman & Hall; Introduction to Economics, 2005

44. Consumption Costs
Any pro-growth policy that works by increasing investment—private or government, in physical capital, human capital, or R&D—requires a sacrifice of current consumption spending
Role of this trade-off in economic growth can be clearly seen with production possibilities frontier (PPF)
Greater investment in physical capital, human capital, or R&D will lead to faster economic growth and higher living standards in the future
But we will have fewer consumer goods to enjoy in the present
Lieberman & Hall; Introduction to Economics, 2005

45. Figure 11: Consumption, Investment, and Economic Growth
Production of Consumption Goods
Production of Capital Goods D K E B A C
Lieberman & Hall; Introduction to Economics, 2005

46. Opportunity Costs of Workers’ Time
Living standards will also rise if a greater fraction of population works or if those who already have jobs begin working longer hours
But this increase in living standards comes at a cost
Decrease in time spent in nonmarket activities
Thus, when economic growth comes about from increases in the employment-population ratio (or in average hours), we face a trade-off
Can enjoy higher incomes and more goods and services
Will have less time to do things other than work in the market
Lieberman & Hall; Introduction to Economics, 2005

47. Sacrifice of Other Social Goals
Rapid economic growth is an important social goal, but not the only goal
Some policies that quicken the pace of growth require us to sacrifice other goals that we care about
But, just as government policies to stimulate investment require us to sacrifice other goals, so, too, can pursuit of other goals impede investment spending and economic growth
We can achieve greater worker safety, a cleaner environment, and other social goals, but we may have to sacrifice some economic growth along the way
Alternatively, we can achieve greater economic growth, but we will have to compromise on other things we care about
Lieberman & Hall; Introduction to Economics, 2005

48. Using the Theory: Economic Growth in the Less-Developed Countries
In most countries, Malthus’s dire predictions have not come true
Less-developed countries (LDCs)
How does a nation go about increasing its capital stock?
Shifting resources away from consumer-goods production toward capital-goods production
Some countries that were once LDCs have applied the formula very effectively
But other LDCs have had great difficulty raising living standards
Much of the explanation for low growth rates of many LDCs lies with three characteristics that they share
Very low current output per capita
High population growth rates
Poor infrastructure
Lieberman & Hall; Introduction to Economics, 2005

49. Using the Theory: Economic Growth in the Less-Developed Countries
These characteristics interact to create a vicious circle of continuing poverty
Which we can understand with the help of the familiar PPF between capital goods and consumption goods
In order to have rising capital per worker—an important source of growth in productivity and living standards
A nation’s stock of capital must not only grow, but grow faster than its population
Poorest LDCs are too poor to take advantage of the trade-off between consumption and capital production in order to increase their living standards
Since they cannot reduce consumption below current levels, they cannot produce enough capital to keep up with their rising population
In recent history, countries have attempted several methods to break out of this vicious circle of poverty
During 1930s, dictator Joseph Stalin simply forced Soviet economy from a point like H to one like J in Figure 12
Millions who complained too loudly, or who otherwise represented a political threat, were rounded up and executed
Lieberman & Hall; Introduction to Economics, 2005

50. Using the Theory: Economic Growth in the Less-Developed Countries
A less-brutal solution to problem of LDCs is to make wealthy bear more of the burden of increasing growth
These moves often backfire in long-run
Since restrictions on personal and economic freedom are remembered long after they are removed
Makes the public—especially foreigners—hesitant to invest in that country
A third alternative—and the one used increasingly since 1940s—is foreign investment or foreign assistance
Variation on this strategy
Foreign nations provide consumer goods so that poorer nation can shift its own resources out of producing them (and into capital production) without causing consumption levels to fall
Another alternative is slowing growth in population
Has been an important (and successful) part of China’s growth strategy
Although it has required severe restrictions on rights of individual families to have children
Lieberman & Hall; Introduction to Economics, 2005

51. Figure 12: LDC Growth and Living Standards
Production of Consumption Goods per Period
Production of Capital Goods per Period C R H J N K S
Lieberman & Hall; Introduction to Economics, 2005

52. Figure 13: Growth Options for LDCsK S
(a)
Production of Capital Goods per Period
Production of Consumption Goods per Period N N'
(b) C T K S
Production of Consumption Goods per Period
Production of Capital Goods per Period
Lieberman & Hall; Introduction to Economics, 2005