Chapter 10: Long-run Economic Growth: Sources and Policiesyluo/teaching/Econ1002EF/chapter10.pdfI The Economic Growth model: Technological change (TC) is the key factor in explaining

Chapter 10: Long-run Economic Growth: Sourcesand Policies

Yulei Luo

SEF of HKU

February 13, 2012

Learning Objectives

1. Define economic growth, calculate economic growth rates,and describe trends in economic growth.

2. Use the economic growth model to explain why growth ratesdiffer across countries.

3. Discuss fluctuations in productivity growth in the UnitedStates.

4. Explain economic catch-up, and discuss why many poorcountries have not experienced rapid economic growth.

5. Discuss government policies that foster economic growth.

Economic Growth Over Time and Around the World

I Real GDP per capita (p. c.) is the best measure of acountry’s standard of living. Economic growth occurs whenreal GDP p. c. increases.

I We consider EG both over time and around the world, andthen discuss why different countries/regions have differentgrowth patterns:

I high SOL initially and continued to grow rapidly (USA,Canada, UK, etc.);

I high SOL initially but failed to keep pace (Argentina);I low SOL initially and still very low today (Some Africancountries);

I low SOL initially but become much richer today (Japan, HongKong, Korea, Taiwan, Singapore, etc.).

7 of 39Copyright © 2010 Pearson Education, Inc. · Macroeconomics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e.

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FIGURE 10-1Average Annual Growth Rates for the World Economy

Economic Growth over Time and around the WorldEconomic Growth from 1,000,000 B.C. to the Present

World economic growth was essentially zero in the years before 1300, and it was very slow—an average of only 0.2 percent per year—before 1800. The Industrial Revolution made possible the sustained increases in real GDP per capita that have allowed some countries to attain high standards of living.

Define economic growth, calculate economic growth rates, and describe global trends in economic growth.

10.1 LEARNING OBJECTIVE

EG from 1,000,000 B.C. to the Present

I No sustained EG occurred between 1, 000, 000 B.C. and 1300A.D. It was estimated that real GDP p.c. was the same(about $140 in 2008 dollars) in both years. It was theminimum amount necessary to sustain life.

I Significant EG did not begin until the industrial revolution.I Industrial Revolution (IR): The application of mechanicalpower to the production of goods, beginning in Englandaround 1750 and spreading to US, FR, GER. It greatlyincreases labor productivity.


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Why Did the IndustrialRevolution Begin in England?

Makingthe

Connection

The British government’s guarantee of property rights set the stage for the Industrial Revolution.

YOUR TURN: Test your understanding by doing related problem 1.3 at the end of this chapter.



Most economists accept the idea that economic growth is not likely to occur unless a country’s government provides the necessary type of institutional framework.

Why did the Industrial Revolution Occur in England?

I IR was a key turning point in human history: Before it, EG isslow and halting. After it, EG is rapid and sustained.

I No consensus so far: why did IR occur in England then?Some arguments:

I Institutions in England differed significantly from those inother countries in ways that greatly stimulated EG.

I After the Glorious revolution, the British Parliament controlledthe gov. and the court system also became independent of theking.

I The British gov. was able to credibly to commit to upholdingprivate property rights, protecting wealth, and eliminatingarbitrary increases in taxes. These changes strengthenedentrepreneurs’s incentive to make new investments.

Small Differences in Growth Rates Are Important

I Small differences in growth rates can have a large impact.I Compounding: The higher interest rate is applied to a largeramount; the lower interest rate is applied to a small amount.

I E.g., Invest $100 in a savings account, two interest rates:1.3% or 2.3%.

I The compounding process magnifies even small difference ingrowth rates over long periods of time:

I E.g., in 1950 real GDP p.c. in Argentina was $6942 (measuredin 2000 dollars), while real GDP in France was $5921. Overthe next 58 years, the EG rate in France averaged 2.7% peryear, while in Arg. it was only 1%.

I This small difference has a large impact on the SOL in bothcountries: in 2008, real GDP p.c. in France had risen to$27, 274, while real GDP in Arg, was only $12, 994.

I (cont.) Growth rates matter because an economy that growstoo slowly fails to raise living standards.

I We can divide the world’s economies into two groups:

1. The high-income countries (the industrial or developedcountries);

2. the developing counties.

I In the 1980s and 1990s, a small group of countries, mostlyEast Asian countries/regions such as Hong Kong, SouthKorea, Taiwan, and Singapore, experienced high rates ofgrowth and are sometimes referred to as the newlyindustrializing countries and regions.


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FIGURE 10-2

GDP per Capita, 2008

Economic Growth over Time and around the World“The Rich Get Richer and . . . ”

GDP per capita is measured in U.S. dollars, corrected for differences across countries in the cost of living.



What Determines How Fast Economies Grow?

I Economic growth (EG) model: A model that explains growthrates in real GDP per capita over the long run.

I Labor productivity (LP): The quantity of goods and servicesthat can be produced by one worker or by one hour of work.

I Economists believe two key factors determine laborproductivity: the quantity of capital per hour worked and thelevel of technology.

I Due to the importance of LP, the EG model focuses on thecauses of long-run increases in LP.

I Technological change: Change in the ability of a firm toproduce output with a given quantity of inputs (capital andlabor).

(cont.) Three main sources of technological change:

1. Better machinery and equipment: Today, continuingimprovements in computers, machine tools, electronicgenerators, and other machines contribute to increases in L.P.

2. Increases in human capital: H.C. is the accumulatedknowledge and skills that workers acquire from education andtraining or from their life experience. As workers increase theirH.C. through education and training, their productivity willalso increase.

3. Better means of organizing and managing production: L.P.will increase if managers can do a better job of organizingproduction. E.g., with some effi cient system, fewer workersare needed to produce the same amount of products and thenthe quantity produced per hour worked will increase.

The Per-Worker Production Function

I Per-worker production function: The relationship between realGDP, or output, per hour worked and capital per hour worked,holding the level of technology constant.

I When holding technology constant, equal increases in theamount of capital p.h. worked lead to diminishing increases inoutput p.h. worked.

I At very high levels of capital p.h. worked, further increases incapital p.h. will not result in any increase in real GDP p.h.

I This effect results from the law of diminishing returns: as weadd more of one input (capital) and let another inputsunchanged, output increases by smaller additional amounts.

Which is More Important for EG: More Capital orTechnological Change?

I Technological change can help economies avoid diminishingreturn to capital (DRTC).

I Some examples of TC include: the replacement of existingcapital with more productive capital; reorganizing howproduction takes place so as to increase output.

I Because of DRTC, continuing increases in real GDP p.h. canbe sustained only if there is technological change.


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FIGURE 10-3The Per-Worker Production Function

What Determines How Fast Economies Grow?The Per-Worker Production Function

The per-worker production function shows the relationship between capital per hour worked and real GDP per hour worked, holding technology constant. Increases in capital per hour worked increase output per hour worked but at a diminishing rate. For example, an increase in capital per hour worked from $20,000 to $30,000 increases real GDP per hour worked from $200 to $350. An increase in capital per hour worked from $30,000 to $40,000 increases real GDP per hour worked only from $350 to $475. Each additional $10,000 increase in capital per hour worked results in a progressively smaller increase in output per hour worked.

Use the economic growth model to explain why growth rates differ across countries.



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s Technological change helps economies avoid diminishing returns to capital.

What Determines How Fast Economies Grow?Which Is More Important for Economic Growth: More Capital or Technological Change?




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FIGURE 10-4Technological Change Increases Output per Hour Worked

What Determines How Fast Economies Grow?Technological Change: The Key to Sustaining Economic Growth

Technological change shifts up the production function and allows more output per hour worked with the same amount of capital per hour worked. For example, along Production function1 with $50,000 in capital per hour worked, the economy can produce $575 in real GDP per hour worked. However, an increase in technology that shifts the economy to Production function2 makes it possible to produce $675 in real GDP per hour worked with the same level of capital per hour worked.




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What Explains the Economic Failure of the Soviet Union?

Makingthe

Connection

The fall of the Berlin Wall in 1989 symbolized the failure of Communism.

YOUR TURN: Test your understanding by doing related problem 2.8 at the end of this chapter.



A centrally planned economy, such as the Soviet Union’s, could not, over the long run, grow faster than a market economy. The Soviet Union collapsed in 1991, and contemporary Russia now has a more market-oriented system, although the government continues to play a much larger role in the economy than does the government in the United States.

Endogenous Growth Theory

I The Economic Growth model: Technological change (TC) isthe key factor in explaining long-run growth in real GDP p.c.

I It was first developed in the 1950s by Robert Solow.I Recently, some economists have become unsatisfied with itbecause it doesn’t explain the factors that determine TC.

I Endogenous growth theory: A model of long-run economicgrowth that emphasizes that technological change isinfluenced by how individuals and firms respond to economicincentives, and so is determined by the working of the marketsystem.

I Endogenous growth theory proposed by Paul Romer, whoargues that the accumulation of knowledge capital is the keydeterminant of EG.

I (cont.) The use of physical capital, such as computer, is:I rival because if one firm uses it other firms cannot;I excludable because the firm that owns the capital can keepother firms from using it.

I However, knowledge capital, such as a chemical formula, isnon-rival and non-excludable because:

I one firm’s using this knowledge doesn’t prevent another firm’susing it;

I once it becomes known, it becomes widely available for otherfirms to use (unless the gov. gives the firm the legal right toexclusive use of it).

I (cont.) Patent: The exclusive right to a product for a periodof 20 years from the date the product was invented.

I Because KC is non-rival and non-excludable, firms can freeride on the R&D of other firms (They benefit from the resultsof R&D they didn’t pay for).

I Firms are thus unlikely to invest in R&D up to theoptimal/effi cient level and there is likely to be an ineffi cientlysmall amount of R&D, slowing the accumulation of KC andeconomic growth.

I However, government policy can help increase theaccumulation of KC.

(cont.) Government policy can help increase KC closer to theoptimal level in three ways:

1. Protecting intellectual property with patents and copyrights:They can increase the firm’s incentive to engage in R&D andthen reduce the ineffi ciency caused by KC.

2. Subsidizing R&D: It can increase the quantity of R&D. In US,the gov carries out some research directly (NIH). It can alsoprovide grants to researchers in universities through NSF andother agencies. Finally, it provides tax benefits.

3. Subsidizing education: It can increase the number of workerswith technical training. The gov. can subsidize edu by directlyproviding free education, support for public colleges and univ,or loans.

Joseph Schumpeter and Creative Destruction

I Schumpeter developed a model of growth in which newproducts will lead to creative destruction in which olderproducts and firms that produced them are driven out of themarket. E.g., DVD player displaced VHS and VCR by bettermeeting consumer demand for watching films at home.

I To Schumpeter, the entrepreneur is central to economicgrowth:

I They have incentives (profits) for bringing together the factorsof production to start new firms and introduce new products.

I Successful entrepreneurs can use their profits to finance thedevelopment of new products and attract more funds frominvestors.

Economic Growth in the United States

I The continuing TC led to rapid EG in the US until the 1970s.Actually, the growth rate of the US accelerated over time untilthen.

I Productivity in the US grew rapidly from the end of WW IIuntil the mid-1970.

I Growth then slowed down for 20 years before increasing againafter 1995.


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FIGURE 10-5Average Annual Growth Rates in Real GDP per Hour Worked in the United States


Economic Growth in the United States since 1950

Discuss fluctuations in productivity growth in the United States.


The growth rate in the United States increased from 1800 through the mid-1970s. Then, for more than 20 years, growth slowed before increasing again in the mid-1990s.

What Caused the Productivity Slowdown of 1973-1995?

I Was it a measurement problem?I Productivity really didn’t slow down during these years. It onlyappears to have slowed down because of problems inmeasuring productivity accurately.

I E.g., The fraction of “services” in GDP became larger and Thefraction of “goods” in GDP became smaller. It is more diffi cultto measure “services” in GDP.

I There may also be a measurement problem in accounting forimprovements in the environment and in health and safety.New laws required firms to spend more to reduce pollution,improving workplace safety, and so on.

I (cont.) Was it the effect of high oil prices?I In 1973, OPEC (an organization that exports oil) increased theprice of oil significantly. The higher oil prices increasedproduction costs for many firms in the US (They use oildirectly or indirectly).

I However, the productivity slowdown continued after US firmshad fully adjusted to high oil prices. In fact, it continued intothe late 1980s and early 1990s when oil prices declined.

I Was it the declining quality of labor?I Deterioration in the US educational system may havecontributed to the slowdown.

I However, it is diffi cult to estimate how much of the slowdownmay have been due to this effect.

I The productivity slowdownn affected all industrial countries:I Therefore, there must have common reasons that can explainthe slowdown experienced in all leading industrial countries.

I Hence, the measurement problem become more plausible.


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FIGURE 10-6Productivity Growth in the Leading Industrial Economies, 1996–2008


Productivity growth as measured by the average annual growth rate of labor productivity was more rapid in the United States than in the other high-income countries during the years between 1995 and 2008.

Discuss fluctuations in productivity growth in the United States.


Productivity Growth in theHigh-Income Economies, 1995-2008

Why has Productivity Growth Been Faster in the U.S. thanin Other Countries?

1. The greater flexibility of US labor markets:I In most Euro. countries, gov. regulations make it diffi cult tofire workers. Consequently, firms are reluctant to hire workersand then younger workers have diffi culty finding jobs.

I In contrast, in the US, gov regulations are less restrictive.Workers can find jobs easily and also change jobs morefrequently that ensures a better match between workers andjobs and then increases LP.

2. The greater effi ciency of the US financial system:I TC is essential to rapid EG.I The effi cient FS in the US aids firms to borrow funds toimplement new technology.


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Why Isn’t the Whole World Rich?

FIGURE 10-7The Catch-up Predicted by the Economic Growth Model

Catch-up: Sometimes, but Not Always

According to the economic growth model, countries that start with lower levels of real GDP per capita should grow faster (points near the top of the line) than countries that start with higher levels of real GDP per capita (points near the bottom of the line).

Explain economic catch-up and discuss why many poor countries have not experienced rapid economic growth.



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FIGURE 10-8There Has Been Catch-up among High-income Countries

Catch-up among High-Income Countries



Looking only at countries that currently have high incomes, countries such as Ireland and Japan that had the lowest incomes in 1960 grew the fastest between 1960 and 2008.Countries such as Switzerland and the United States that had the highest incomes in 1960 grew the slowest.




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FIGURE 10-9Most of the World Hasn’t Been Catching Up

Are the Developing Countries Catching Up to theHigh-income Countries?



Looking at all countries for which statistics are available does not show the catch-up predicted by the economic growth model. Some countries that had low levels of real GDP per capita in 1960, such as Niger, Madagascar, and the Democratic Republic of the Congo, actually experienced negative economic growth. Other countries that started with low levels of real GDP per capita, such as Malaysia and South Korea, grew rapidly. Some middle-income countries in 1960, such as Venezuela, hardly grew between 1960 and 2008, while others, such as Israel, experienced significant growth.




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Solved Problem 10-4The Economic Growth Model’s Prediction of Catch-up

COUNTRY

REAL GDPPER CAPITA IN 1960

(2000 DOLLARS)

ANNUAL GROWTHIN REAL GDP

PER CAPITA, 1960–2008

Taiwan $1,443 6.01%

Tunisia 2,102 3.14

Brazil 2,643 2.37

Algeria 3,843 1.05

Japan 4,509 3.73

Italy 7,167 2.47

Venezuela 7,838 0.82

United Kingdom 10,323 2.14

New Zealand 12,063 1.41

YOUR TURN: For more practice, do related problems 4.4 and 4.5 at the end of this chapter.



Why don’t More Low-Income Countries Experience RapidGrowth?

1. Failure to enforce the rule of lawI Rule of Law: The ability of a gov. to enforce the laws of thecountry, particularly with respect to protecting private propertyand enforcing contracts.

2. Wars and revolutions made it impossible for countries toaccumulate enough capital stock or adopt new technologies.And conducting any kind of businesses was very diffi cult.

3. Poor public education and healthI Many low-income countries have weak public school systems,so many workers are unable to read and write.

I People who are sick work less and are less productive whenthey do work.

4. Low rates of saving and investment: The low savings rates indeveloping countries contribute to a vicious cycle of poverty.

The Benefits of Globalization

I Foreign direct investment: When corporations build orpurchase facilities in foreign countries.

I Foreign portfolio investment: The purchase by an individual orfirm of stock or bonds issued in another country.

I Globalization: The process of countries becoming more opento foreign trade and investment.


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The Benefits of Globalization

FIGURE 10-10Globalization and GrowthDeveloping countries that were more open to foreign trade and investment grew much faster during the 1990s than developing countries that were less open.



Growth Policies

I Even small differences in growth rates compounded over theyears can lead to major differences in SOL. Therefore, there ispotentially a very high payoff to government policies thatincrease growth rates:

I Enhancing property rights and the rule of law increasedpolitical stability is a necessary prerequisite to EG.

I Improving health and education: As people’s health improves,they will become more productive. Lucas argued thatproductivity increases as H.C. increases. Gov. should subsidizeeducation to promote EG.

I Policies with respect to technology: Subsidizing R&D.I Policies with respect to saving and investment Increase theincentives to save and invest.

Key Terms in Chapter 9

I Industrial RevolutionI Labor productivityI Technological changeI Human capitalI Per-worker production functionI Economic growth modelI Endogenous growth theoryI Catch-upI Foreign direct investment (FDI); foreign portfolio investment;globalization

Documents

Chapter 10: Long-run Economic Growth: Sources and Policiesyluo/teaching/Econ1002EF/chapter10.pdfI The Economic Growth model: Technological change (TC) is the key factor in explaining