ECONOMIC GROWTH

17
CHAPTER
The Basics of Economic Growth

U.S. real GDP per person and the standard of living tripled
between 1960 and 2010.

We see even more dramatic change in China, where

incomes have tripled not in 50 years but in the 13 years
since 1999.

Incomes are growing rapidly in some other economies of

Asia, Africa, and South America.

What are the forces that make real GDP grow?

The Basics of Economic Growth

Economic growth is the sustained expansion of production

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

Calculating Growth Rates

The economic growth rate is the annual percentage

change of real GDP.

The economic growth rate tells us how rapidly the total

economy is expanding.
The Basics of Economic Growth

The standard of living depends on real GDP per person.

Real GDP per person is real GDP divided by the

population.

Real GDP per person grows only if real GDP grows faster
than the population grows.
The Basics of Economic Growth

Economic Growth Versus Business Cycle Expansion

Real GDP can increase for two distinct reasons:

1. The economy might be returning to full employment in an

expansion phase of the business cycle.

2. Potential GDP might be increasing.

The return to full employment in an expansion phase of the

business cycle isn’t economic growth.

The expansion of potential GDP is economic growth.

The Basics of Economic Growth
This Figure illustrates the
distinction.
A return to full employment
in a business cycle
expansion is a movement
from inside the PPF (point
A) to a point on the PPF
(point B).
Economic growth is the
outward shift of the PPF
from PPF0 to PPF1 and the
movement from point B on
PPF0 to point C on PPF1.
Growth Rates Matter

Compound Interest
We all know the power of compound interest, but it is worth
reminding ourselves of it.
Consider a fifty year time period. The table below shows
what happens to output per head at different growth rates:
2.1% per annum Increases 182.7%

1.5% per annum Increases 110.5%

3.0% per annum Increases 338.4%

1.0% per annum Increases 64.5%

4.0% per annum Increases 610.7%

Growth Rates Matter

The Magic of Sustained Growth

The Rule of 70 states that the 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.
Growth Rates Matter

Applying the Rule of 70

This Figure shows the
doubling time for growth
rates.
A variable that grows at
7 percent a year doubles
in 10 years.
A variable that grows at
2 percent a year doubles
in 35 years.
A variable that grows at
1 percent a year doubles
in 70 years.
Long-Term Growth Trends

Real GDP Growth in the

World Economy
This Figure shows the
growth in the rich
countries.

Japan grew rapidly in

the 1960s, slower in the
1980s, and stagnated
during the 1990s.

Growth in Europe Big 4,

Canada, and the United
States has been similar.
Economic Growth Trends

This Figure shows the

growth of real GDP per
person in a group of
poor countries.
The gaps between real
GDP per person in the
United States and in
these countries have
widened.
The Causes of Economic Growth:
A First Look

Preconditions for Economic Growth

The basic precondition or prerequisite for economic growth is an

appropriate incentive system.

Three institutions that help with the creation of appropriate incentives

are:
 Competitive Markets
 Monetary exchange, i.e., proper Flow of liquidity
 Clear and certain property rights together with strong liability rule
The Causes of Economic Growth:
A First Look

For economic growth to persist, society somehow needs to

ensure these three activities:

 Saving and investment in new capital

 Investment in human capital
 Discovery of new technologies

Appropriate incentives allow these activities to occur in a

decentralized market, society.
 The Causes of Economic Growth:
A First Look
Note that, Potential GDP, Y = F(L, K, T )
Saving and Investment in New Capital
The accumulation of capital dramatically increases output and productivity;
one US farmer can feed many, many households.
Investment in Human Capital
Human capital acquired through education, on-the-job training, and learning-
by-doing can also dramatically increase output and productivity.
Discovery of New Technologies
Technological advances contribute immensely to increasing productivity; think
what you can do with a PC, things that were impossible for your parents
without months of work.
Growth Accounting

The quantity of real GDP supplied, Y, depends on the

quantity of labor, L, the quantity of capital, K, and the state
of technology, T.
The purpose of growth accounting is to estimate how
much real GDP growth comes from growth of labor and
capital inputs, and how much is apparently because of
technological change
Growth accounting is based on the aggregate production
function,
Y = F(L, K, T ).
Growth Accounting

Labor Productivity
Labor productivity is real GDP per hour of labor or per
unit of labor; it equals real GDP divided by aggregate
hours or real GDP divided by total number of labor.

So, Labor productivity =

Growth Accounting

Growth accounting divides growth in productivity into two

sources:
 Growth in capital per unit of labor
 Technological change
Any productivity growth not accounted for by growth in
capital is allocated to technological change, so this
category is a broad catch-all concept, which also includes
for example efficiency improvements from better
organization, economic system, or management.
Growth Accounting

Assume a Cobb-Douglas CRTS Production Function:

For any , denote

Equation of the productivity curve

Growth Accounting

A general rule

Applying this general rule:

Intensive Extensive
growth growth

R&D Private
investments
Productivity Curve

The Productivity Curve

The productivity curve is the relationship between output
per worker and capital per worker, with technology held
constant.

𝛼and are positively related

𝑦 =𝑇 𝑘 The relationship is governed by
𝑦 𝑦 𝑦

linear Convex Concave

𝑘 𝑘 𝑘
𝛼 =1 𝛼> 1 𝛼< 1
Productivity Curve
1
Micro-level analysis using firm-level data 𝛼
reveals:=
3
Note that:
Slope

Elasticity
𝑦

Concave

𝑘
Productivity Curve
 Productivity Curve

This Figure
illustrates the
productivity curve.
An increase in capital
per worker brings a
movement along the
productivity curve. The
slope of the productivity
curve reflects the rate
of return or the real
interest rate earned on
capital.
Technological
improvement shifts the
productivity curve
upward.
Productivity Curve

The shape of the productivity curve reflects the law of

diminishing returns.
The law of diminishing returns states that, as the
quantity of one input increases with the quantities of all
other inputs remaining the same, output increases but
eventually by ever smaller increments.
Robert Solow discovered that diminishing returns are well
described by the one-third rule: with no change in
technology, on the average, a 1 percent increase in capital
per hour of work brings a one-third of 1 percent increase in
output per hour of labor.
Growth Theories

Classical Growth Theory

Classical growth theory came to the conclusion that real
GDP growth was temporary; when real GDP per person
rises above the subsistence level, a population explosion
brings real GDP per person back to the subsistence level.
This may sound stupid now, but in the early 1800s it was a
not unreasonable conclusion – it was not clear that living
standards in most of the world were any higher than in
Roman times.
Growth Theories
Growth Theories

The basic classical idea

There is a subsistence real wage rate, which is the
minimum real wage rate needed to maintain life and match
births to deaths.
Advances in technology shifts the productivity curve up.
Labor productivity increases and the real wage rate rises
above the subsistence level.
When the real wage rate is above the subsistence level,
the population grows – births exceed deaths.
Population growth increases the supply of labor, which
lowers the real wage rate.
Growth Theories

The population continues to increase until the real wage

rate has been driven back down to the subsistence real
wage rate, where deaths match births again.
At this real wage rate, both population growth and
economic growth stop.
Contrary to the assumption of the classical theory, the
historical evidence is that population growth is not tightly
linked to income per person, and rising incomes do not
result in population growth driving incomes back down to
subsistence levels.
Growth Theories

This Figure
illustrates
the
classical
growth
theory.
Growth Theories

Neoclassical Growth Theory

Neoclassical growth theory posits that 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 stops.
Growth Theories

The neoclassical economics of population growth

The neoclassical view is that the population growth rate is
independent of both real GDP per person and its growth
rate.
The population growth rate equals the birth rate minus the
death rate.
The birth rate is influenced by the opportunity cost of a
woman’s time.
As women’s wage rates have increased, the opportunity
cost of having children has also increased and the birth
rate has fallen.
Growth Theories

The death rate is influenced by nutrition, sanitation, public

health policy, and the quality and availability of health care.
As the quality and availability of health care has improved,
the death rate has fallen.
The falls in both the birth rate and the death rate have
tended to offset each other and to make the population
growth rate independent of the level of income; in most
high-income societies the death rate exceeds the birth rate
and population is tending to fall [immigration and an
unusually high birth rate make the US an exception].
Growth Theories

Target Rate of Return and Saving

Ceteris paribus, the higher the real interest rate, the
greater is the amount that people save. To decide how
much to save, people compare the real interest rate
with a target rate of return. If the real interest rate
exceeds the target rate of return, saving is sufficient to
make capital per hour of labor grow. If the target rate of
return exceeds the real interest rate, saving is not
sufficient to maintain the current level of capital per
hour of labor, so capital per hour of labor shrinks. And
if the real interest rate equals a target rate of return,
saving is just sufficient to maintain the quantity of
capital per hour of labor at its current level.
Growth Theories

The basic neoclassical idea

Technology begins to advance more rapidly.
New profit opportunities arise.
Investment and saving increase.
As technology advances and the capital stock grows, real
GDP per person rises.
Diminishing returns to capital per hour of labor lower the
real interest rate and eventually growth stops unless
technology keeps on advancing.
 Growth Theories

This
Figure
illustrates
neo-
classical
growth
theory.
Growth Theories
New Growth Theory
“New growth theory” holds that real GDP per person
grows because of choices that people make in the pursuit
of profit and concludes that growth can persist indefinitely.
The theory emphasizes that
 People are always in pursuit of profit
 Discoveries bring profit
 In a market economy, profit brings competition and
competition destroys profit
 People look for more profit, more discoveries take place,
more knowledge is gathered, more growth takes place
 Knowledge is not subject to diminishing returns
 Growth Theories

This
Figure
illustrates
new
growth
theory.
Growth Theories
This Figure summarizes the ideas of new growth theory as
a perpetual motion machine.