Chapter 6: Economic Growth

• Estimate economic growth and implications of sustained growth for standard of living.

• Trends in economic growth in U.S. and rest of world.

• Sources of economic growth

• Alternative theories and policies to improve growth.

The Basics of Economic GrowthEconomic growth

• the sustained expansion of production possibilities

• measured as the increase in real GDP over a given period.

Economic growth rate = annual % change of real GDP.

• Between two consecutive years:

growth rate = (X2/X1)-1

• Over several years:

Annualized growth rate = (XT/X1)1/T – 1

The Basics of Economic Growth

• Standard of living depends on real GDP per person.

• Real GDP per person grows only if real GDP grows faster than the population grows.

• Rule of 70

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

Trends in U.S Economic Growth

Growth in the U.S. Economy

From 1908 to 2008, annual growth in real GDP per person in the United States averaged 2% .

Real GDP per person fell precipitously during the Great Depression and rose rapidly during World War II.

Growth was most rapid during the 1960s.

Growth slowed during the 1970s and sped up again in the 1980s and1990s.

Economic Growth Trends

Economic Growth in U.S. vs. Poor Countries

The gaps between real GDP per person in the United States and in these countries have widened.

Some economies are converging

Some are diverging

Sources of Economic Growth

Economic growth is the sustained, year-on-year increase in potential GDP.

• Potential GDP is the quantity of real GDP produced when the quantity of labor employed is the full-employment quantity.

• Short run fluctuations in real GDP resulting from the business cycle are not the basis for economic growth

Determinants of Potential GDPAggregate production function

• Real GDP changes as the quantity of labor changes, other things held constant.

• An increase in labor increases real GDP.

• Diminishing marginal returns cause RGDP to rise at slower rate as L rises

Determinants of Potential GDP

Aggregate Labor Market

• real wage rate– money wage rate divided by the price level.

• demand for labor– shows the quantity of labor demanded as a

function of the real wage rate.– determined by the marginal product of labor

• supply of labor –shows the quantity of labor supplied as a

function of the real wage rate.

The Labor Market and Potential GDP

Labor Demand Curve

The demand for labor is the relationship between the quantity of labor demanded and the real wage rate when all other influences on hiring plans remain the same.

Marginal product of labor curve is same as labor demand curve

Firms will always hire workers if MP> real wage

Profit maximizing firm hires until MP= real wage

The Labor Market and Potential GDP

Labor supply curve

shows quantity of labor supplied for each real wage rate.

Quantity of labor supplied increases as the real wage rate increases for two reasons:

1. Hours per person increase (assuming IE<SE)

Income effect (work less if real wage increases)

Substitution effect (work more if real wage increases)

2. Labor force participation increases

Determinants of Potential GDP

How Potential GDP Grows

Increase in the supply of labor

• taxes on workers

• population growth

• demographics

• retirement incentives

• household technology

Increase in demand for labor

• more productive labor

• Human capital

• physical capital

• technological improvements

• reduced payroll taxes on employers

Effect of increase in labor supply

• real wage

• labor hours

• real GDP

• productivity (RDGP per hour)

• real GDP per capita

• depends on whether population increased

Effect of increase in labor demand due to increased productivity

• Labor demand increases and PF shifts upward.

• real wage

• labor hours

• real GDP

• productivity

• real GDP per capita

The incentive system created by firms, markets, property rights, and money.

The growth of labor productivity depends on

• Physical capital growth• Human capital growth• Technological advances

Why Labor Productivity Grows

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.

Growth accounting

• calculates the contribution of capital growth and technological change to labor productivity growth.

One third rule (Robert Solow)

• Estimated effects of capital on labor productivity

• On average, with no change in technology, a 1 percent increase in capital per hour of labor brings a 1/3 percent increase in labor productivity

Accounting for Growth

Why Labor Productivity Grows

Between 1973 and 1983, growth of labor productivity slowed to 1.7 percent a year.

A collapse in the contribution of technological change (purple bar) brought about this slowdown in the growth of labor productivity.

Why Labor Productivity Grows

Labor productivity growth rate increased to 2 percent a year between 1983 and 1993 and …

to almost 3 percent between 1993 and 2008.

Technological change contributed most to this speedup in the growth of labor productivity.

Growth Theories and Policies

Classical growth theory

• growth of real GDP per person is temporary and that when GDP per person rises above the subsistence level, a population explosion eventually brings real GDP per person back to the subsistence level.

• Malthus – the “dismal science”

Growth Theories and Policies

Modern Growth Theory

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 and/or incentives for technological change stops.

Growth Theories and Policies

New growth theories

• Real GDP per person grows because of choices that people make in the pursuit of profit and growth can persist indefinitely.

• Technological change is driven by profit incentives

• Knowledge is a public good and there may be increasing returns to knowledge (education)

Achieving Faster Growth

Growth accounting tells us that to achieve faster economic growth we must either increase the growth rate of capital per hour of labor or increase the pace of technological change.

Stimulate Saving

• Saving finances investment. So higher saving rates might increase physical capital growth.

• Tax incentives might be provided to boost saving.

Growth Theories and Policies

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.

• The market might allocate too few resources to research and development.

• Government subsidies and direct funding might stimulate basic research and development.

• Patents can provide incentive to innovate.

Growth Theories and Policies