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Economic Growth

Chapter 16. Economic Growth. 1. The Importance of Economic Growth. LRAS. LRAS. 1990. 2000. SRAS. SRAS. 1990. 2000. PP. 2000. PP. C onsumption G oods. P rice L evel. AD. 2000. AD. B. 1990. A. Y. Y. 1990. 2000. P. P. 1. 1. 1990. R eal G DP. C apital G oods. A. B.

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Economic Growth

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  1. Chapter 16 Economic Growth

  2. 1. The Importance of Economic Growth

  3. LRAS LRAS 1990 2000 SRAS SRAS 1990 2000 PP 2000 PP ConsumptionGoods PriceLevel AD 2000 AD B 1990 A Y Y 1990 2000 P P 1 1 1990 RealGDP CapitalGoods A B The Importanceof Economic Growth • Economic growth expands the sustainable output rate (YF) of an economy. • This can be illustrated by either an outward shift in the production possibilities curve . . . or an increase in long-run aggregate supply (a shift from LRAS1990 to LRAS2000). • If monetary policy maintains the initial price level (P1), equilibrium real GDP will increase from Y1990 to Y2000.

  4. Per-Capita Income(in Thousands of 1985 U.S. Dollars) 0 5 10 15 20 4,462 Argentina 1960 6,333 1997 6,338 Venezuela 6,505 2,954 Japan 15,900 2,247 Hong Kong 19,774 Source: Robert Summers and Alan Heston, Penn World Tables (Cambridge: National Bureau of Economic Research, 1994). These data were through 1992. They were updated to 1997 by the authors. The Importanceof Economic Growth • Differences in sustained growth rates over 2 or 3 decades will substantially alter the relative incomes of countries. • The per-capita incomes for Argentina, Venezuela, Japan, and Hong Kong in 1960 are indicated below. • During the 1960-1997 period, the per capita growth rates of Argentina and Venezuela were 1% and 0.1% respectively . . . in contrast, the annual growth rates of Japan and Hong Kong were 4.7% and 6% respectively. • Note how the more rapid growth rates of the two Asian nations drastically altered their relative incomes compared to those of the two Latin American countries.

  5. = 28 The Importance of Economic Growth • The Rule of 70: • Dividing 70 by a country’s average growth rate gives the number of years required for an income level to double. • Example:If the U.S. had a growth rate of 2.5%, how many years would it take for the income level of the U.S. to double? 70 28 Years. 2.5

  6. 2. Differences in Growth Rates Among Nations

  7. Of High-income Industrial Countries, The Growth Of Per-capita GDP (1980–1998) High-Growth LDCs, And Low-Growth LDCs High-Income Growth Of Low Growth Of High- Growth Of Industrial Growth Per-capita GDP Per-capita GDP Per-capita GDP Growth b a Countries LDCS 1980–1998 1980–1998 1980–1998 LDCS China 8.2 Japan 2.3 Congo (Zaire) -5.3 South Korea 6.4 United Kingdom 1.9 Togo -4.1 Taiwan 5.4 Germany 1.8 Niger -3.9 Singapore 5.4 United States 1.8 Haiti -3.6 Thailand 4.9 Australia 1.8 Nicaragua -3.0 Ireland 4.3 Italy 1.7 Madagascar -3.0 Hong Kong 4.2 France 1.5 Cameroon -2.8 Netherlands 1.5 Côte d’lvoire -2.6 Canada 1.1 Zambia -2.3 Source: Derived from World Bank, World Tables, CD-Rom. Only countries with a population of 2 million or more are included in this table. In a few cases, the 1998 data were unavailable. When this was true, the growth rate was for the 1980-1997 period. Switzerland 0.7 Romania -2.2 Differences in Growth Rates Among Nations • The growth of LDCs (less- developed countries) is characterized by diversity. • The fastest growing countries in the world are LDCs . . . although other LDCs are doing very poorly.

  8. 3. Sources of Economic Growth

  9. Sources ofEconomic Growth • Investment in physical and human capital • Technological advances • Institutions and policies consistent with efficient economic organization, such as: • Secure property rights and political stability, • Competitive markets, • Stable money and prices, • Free trade, • Open capital markets, and, • Avoidance of high marginal tax rates.

  10. 4. The Size of Government and Economic Growth

  11. The Size of Government and Economic Growth • A Government that focuses on protective and productive activities in which it has a comparative advantage, can enhance growth. • Continued growth of government will eventually exert a negative impact on the economy, for 4 major reasons: • Higher taxes and/or additional borrowing will impose increasing deadweight losses on the economy. • Diminishing returns will cause the rate of return derived from government activities to fall. • The political process is much less dynamic than the market process. • A larger government becomes more heavily involved in the redistribution of income and regulatory activities.

  12. Growth Rate of the Economy B 6 3 0 Size of Government (As a Percent of GDP) Size of Government—Growth Curve A • If governments undertake activities in the order of their productivity, governments would, at first, promote economic growth (increasing the size of government from A to B) . . . at some point, though, additional expenditures eventually would retard growth (increasing the size of government beyond B decreases the growth rate of the economy).

  13. Respective Decade Long Growth Rate Growth = 7.84 - 1.16 (Gov’t Expenditures) (-9.68) Adj. R-Sq = .53 Linear trend 10.0 8.0 6.0 4.0 2.0 0.0 0.0 10.0 20.0 30.0 40.0 50.0 60.0 70.0 Total Government Expenditures (at beginning of respective decade) Source: Derived from OECD Historical Statistics: 1960-1994 and OECD Economic Outlook: June 1999. The analysis presented here is based upon 84 observations (4 decades and 21 OECD countries for which data were available). Government Spending and Economic Growth Among OECD Countries: 1960-1996 • Here we show the relationship between the size of government at the beginning of the decade and the growth rate of real GDP for that decade (by decade for the 1960s, 70s, 80s, and 90s). • These data indicate that a 10% increase in government expenditures as a share of GDP reduces the annual rate of growth by about 1%.

  14. 5. Economic Freedom and Growth

  15. Economic Freedom and Growth • Economists since the time of Adam Smith have generally argued that freer economies are likely to be more productive. • Economic freedom is complex and very difficult to measure. • The Fraser Institute has developed a measure of economic freedom. Their index indicates that economic freedom is highest with: • consistency of the legal structure, • policies with secure property, • monetary stability, • free trade, and, • reliance on markets.

  16. 9.6 4.2 9.4 4.2 4.2 9.2 4.2 9.1 4.2 9.0 8.8 4.1 The Most Free And Least Free Economies In The World 8.7 4.1 4.1 8.6 3.5 8.6 Hong Kong 1 Ukraine 108 3.2 8.6 Singapore 2 C. Afr. Rep. 108 8.6 3.1 New Zealand 3 Algeria 108 2.5 8.6 United States 4 Madagascar 108 Unit. Kingdom 5 Romania 108 Canada 6 Malawi 113 Argentina 7 Sierra Leone 113 Netherlands 8 Albania 113 Panama 8 Rwanda 116 Australia 8 Congo, Dem. 117 Luxembourg 8 Guin.-Bissau 118 Ireland 8 Myanmar 119 0 3 6 9 0 3 6 9 Source: James Gwartney and Robert Lawson, Economic Freedom of the World: 1998-1999 Interim Report. The Most and Least Free Economies of the World • The Fraser Institute was able to assemble the required data to rate the economic freedom of 119 economies in 1997. The summary ratings presented here are based on data for 25 different components designed to identify the consistency of institutions and policies with economic freedom. The country ratings varied greatly. • Note that this index was designed to measure economic freedom rather than political freedom, civil liberties, or degree of democracy. Most Free Economies Least Free Economies

  17. Thousands 6 5 4 20 3 2 14829 1 0.1 10 0 -1 2.9 2541 -2 1.8 0 -3 1.1 5 4 3 2 1 5 4 3 2 1 12369 1995 Economic Freedom Quintile 1995 Economic Freedom Quintile 6385 3057 -1.9 Source: James Gwartney and Robert Lawson, Economic Freedom of the World: 1998-1999 Interim Report. Economic Freedom and Economic Growth (a) Per-capita GDP (1995 U.S. dollars) (b) Growth of real GDP per capita, 1985–1996 • Countries with more economic freedom, as measured by the Freedom Index in 1995, also had higher than average per capita GDP and more rapid average growth rates during 1985-1995.

  18. 6. Is the Growth Trend of the U.S. Changing?

  19. 4.4 3.2 2.8 2.5 Annual Growth Rate of Real GDP 8.0 4.0 0.0 Year -4.0 1960 1970 1980 1990 1998 (a) Growth of real GDP Change in Output per Hour Worked 3.2 2.0 1.2 1.5 8.0 4.0 0.0 Year -4.0 1960 1970 1980 1990 1998 (b) Change in output per hour worked Source: Economic Report of the President, 1999, Tables B-2 & B-50 Is the Growth Trend in the U.S. Changing? • Despite the unprecedented stability of the U.S. economy during the past 15 years, the average growth rate of real GDP has fallen during each of the last three decades. • The growth of output per hour worked during the ‘80s and ‘90s was less than half the rate achieved during the ‘60s.

  20. Is the Growth Trend in the U.S. Changing? • Factors favorable to economic growth in the U.S. include: • the persistent low rate of inflation, • freer international trade, • a smaller share of output going to government, and, • the fact that a large part of the work force is just moving into their most productive years. • These favorable factors may now be exerting a positive impact on growth: • During 1995-1998, the average growth rate of real GDP was 3.5%, better than that of the ‘70s and ‘80s. • The next couple of years will tell whether the recent upturn in growth is temporary or more long-term.

  21. 1. What can government do to promote economic growth? Is the role of government important? Why or why not? As the size of government increases as a share of the economy, how is the growth rate of real GDP likely to be affected? Questions for Thought: 2. Discuss the importance of the following as determinants of economic growth: (a) natural resources, (b) physical capital, (c) human capital, (d) technological advances, and, (e) economic policy. 3. “Since government-operated firms do not have to make a profit, they can usually produce at a lower cost and charge a lower price than privately owned enterprises.” Evaluate this view.

  22. EndChapter 16

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