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CHAPTER 10: Economic Growth. CHAPTER CHECKLIST. Define and calculate the economic growth rate, and explain the implications of sustained growth. Identify the main sources of economic growth.

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CHAPTER 10:Economic Growth

### CHAPTER CHECKLIST

• Define and calculate the economic growth rate, and explain the implications of sustained growth.

• Identify the main sources of economic growth.

• Review the theories of economic growth that explain why growth rates vary over time and across countries.

• Describe policies that might speed economic growth

### LECTURE TOPICS

• The Basics of Economic Growth

• The Sources of Economic Growth

• Theories of Economic Growth

• Achieving Faster Growth

### 10.1 THE BASICS OF ECONOMIC GROWTH

• Economic growth is a sustained expansion of production possibilities measured as the increase in real GDP over a given period.

• Calculating Growth Rates

• Economic growth rate

• The rate of change of real GDP expressed as a percentage per year.

• Real GDP in current year

Real GDP in previous year

Growth of real GDP =

x 100

Real GDP in previous year

Growth of real GDP =

\$8.4 trillion – \$8.0 trillion

x 100

= 5 percent.

\$8.0 trillion

### 10.1 THE BASICS OF ECONOMIC GROWTH

• To calculate this growth rate, we use the formula:

• For example, if real GDP in the current year is \$8.4 trillion and if real GDP in the previous year was \$8.0 trillion, then the growth rate of real GDP is :

### 10.1 THE BASICS OF ECONOMIC GROWTH

• The standard of living depends on real GDP per person.

• Real GDP per person

• Real GDP divided by the population.

• The contribution of real GDP growth to the change in the standard of living depends on the growth rate of real GDP per person.

### 10.1 THE BASICS OF ECONOMIC GROWTH

• We use the above formula to calculate this growth rate, replacing real GDP with real GDP per person.

• Suppose, for example, that in the current year, when real GDP is \$8.4 trillion, the population is 202 million.

• Then real GDP per person is \$8.4 trillion divided by 202 million, which equals \$41,584.

• And suppose that in the previous year, when real GDP was \$8.0 trillion, the population was 200 million.

• Then real GDP per person in that year was \$8.0 trillion divided by 200 million, which equals \$40,000.

\$41,584 – \$40,000

Growth rate of real GDP per person

x 100

= 4 percent.

=

\$40,000

### 10.1 THE BASICS OF ECONOMIC GROWTH

• Use these two values of real GDP per person in the growth formula to calculate the growth rate of real GDP per person. It is:

Growth of real GDP per person

Growth rate of real GDP

Growth rate of population

=

Growth of population

202 million – 200 million

x 100

= 1 percent.

=

200 million

### 10.1 THE BASICS OF ECONOMIC GROWTH

• The growth rate of real GDP per person can also be calculated by using the formula:

[This formula is an approximation, which is acceptably accurate for ‘normal’ rates of economic and population growth – ten percent a year or less]

Growth of real GDP per person

=

5 percent – 1 percent

= 4 percent.

### 10.1 THE BASICS OF ECONOMIC GROWTH

• This formula makes it clear that real GDP per person grows only if real GDP grows faster than the population grows.

• If the growth rate of the population exceeds the growth of realGDP, real GDP per person falls.

### 10.1 THE BASICS OF ECONOMIC GROWTH

• The Magic of Sustained Growth

• Sustained growth of real GDP per person can transform a poor society into a wealthy one. The reason is that economic growth is like compound interest.

• Rule of 70

• The number of years it takes for the level of any variable to double is approximately 70 divided by the annual percentage growth rate of the variable.

### 10.1 THE BASICS OF ECONOMIC GROWTH

Table 10.1 Growth Rates

Growth rateYears forExample(percentlevel toper year)double

2 35 U.S. real GDP per person

7 10 China real GDP per person

### 10.2 SOURCES OF ECONOMIC GROWTH

• To understand what determines the growth rate of real GDP, we must understand what determines the growth rates of the factors of production [the inputs] and the rate of increase in their productivity.

• All the influences on real GDP growth can be divided into those that increase:

• Aggregate hours

• Labor productivity

### 10.2 SOURCES OF ECONOMIC GROWTH

• Aggregate Hours

• Over time, aggregate hours increase. In rich countries, this growth in aggregate hours typically comes from growth in the labor force rather than from growth in average hours per worker.

• While the participation rate has increased over the past few decades, it has an upper limit, and most of the growth of aggregate hours comes from population growth [including immigration].

• So population growth is the only source of growth in aggregate labor hours that can be sustained over long periods of time.

### 10.2 SOURCES OF ECONOMIC GROWTH

• Labor Productivity

• Labor productivity

• The quantity of real GDP produced by onehour of labor.

• It is calculated by using the formula:

Real GDP

Labor productivity =

Aggregate hours

\$8,000 billion

Labor productivity =

= \$40 per hour

200 billion

### 10.2 SOURCES OF ECONOMIC GROWTH

• For example, if real GDP is \$8,000 billion and if aggregate hours are 200 billion, then we can calculate labor productivity as:

You can turn this formula around and see that:

Real GDP = Aggregate hours x Labor productivity

### 10.2 SOURCES OF ECONOMIC GROWTH

• When labor productivity grows, real GDP per person grows, so the growth in labor productivity is the basis of rising living standards.

• Growth of labor productivity can result from four things:

• Saving and investment in physical capital

• Expansion of human capital

• Discovery of new technologies

• Improved organization, management, or economic system

### 10.2 SOURCES OF ECONOMIC GROWTH

• Saving and Investment in Physical Capital

• Saving and investment in physical capital increase the amount of capital per worker and this can increase labor productivity.

• Expansion of Human Capital

• Human capital—the accumulated skill and knowledge of people—comes from two sources:

• Education and training

• Job experience

### 10.2 SOURCES OF ECONOMIC GROWTH

• Discovery of New Technologies

• To reap the benefits of most technological change, capital must increase.

• Some of the most powerful and far-reaching technologies are embodied, at least partly, in human capital.

• For example, language, writing, and mathematics.

• But most technologies are embodied in physical capital.

• Productivityalso depends on how well production is organized, and the economic system in place. Russia has excellent human capital, lots of physical capital, and large amounts of natural resources; but labor productivity is low because the economic system and the organization of production are still very far from the most appropriate for permitting high output and output growth.

• Better management, better organization, and a better economic system can make large differences to output per labor hour, i.e. labor productivity.

### 10.2 SOURCES OF ECONOMIC GROWTH

Figure 10.1 shows the sources of recent US economic growth.

Real GDP growth depends on aggregate labor hours growth and on labor productivity growth.

### 10.2 SOURCES OF ECONOMIC GROWTH

• Aggregate hours growth depends on:

• Population growth

• The labor force participation rate

• Average hours per worker

### 10.2 SOURCES OF ECONOMIC GROWTH

• Labor productivity growth depends on:

• Physical capital growth

• Human capital growth

• Improved organization, management, and system

### 10.2 SOURCES OF ECONOMIC GROWTH

• The Productivity Curve

• Productivity curve

• The relationship between real GDP per hour of labor and the quantity of capital per hour of labor with a given state of technology.

• As capital/labor increases, output/labor increases; but with fixed technology, eventually output/labor will increase at progressively slower rates – diminishing returns.

### 10.2 SOURCES OF ECONOMIC GROWTH

Figure 10.2 shows how labor productivity grows.

1. An increase in capital per hour of labor brings a movement along the productivity curve PC0.

When capital per hour of labor increases from \$30 to \$60, real GDP per hour of labor increases from \$20 to \$25.

### 10.2 SOURCES OF ECONOMIC GROWTH

2. An increase in human capital and/or a technological advance shift the productivity curve upward from PC0 to PC1.

With this increase in human capital and/or technological advance, real GDP per hour of labor increases from \$20 to \$25 when there is \$30 of capital per hour of labor and from \$25 to \$32 when there is \$60 of capital per hour of labor.

### 10.2 SOURCES OF ECONOMIC GROWTH

• Diminishing Returns

• The shape of the productivity curve reflects the law of diminishing returns, which states that:

• As the quantity of one input increases with the quantities of all other inputs remaining the same, output increases but by ever smaller increments.

### 10.2 SOURCES OF ECONOMIC GROWTH

• The One Third Rule

• By studying growth in the U.S. economy, Robert Solow of MIT observed a one third rule:

• One third rule

• The observation that on the average, with no change in human capital and technology, a one percent increase in capital per hour of labor brings a one third percent increase in labor productivity.

### 10.3 THEORIES OF ECONOMIC GROWTH

• The three growth theories that we will describe briefly are:

• Classical growth theory

• Neoclassical growth theory

• New growth theory

### 10.3 THEORIES OF ECONOMIC GROWTH

• Classical Growth Theory

• Classical growth theory

• The theory that the clash between an exploding population and limited resources will eventually bring economic growth to an end.

• Malthusian theory

• Another name for classical growth theory—named for Thomas Robert Malthus.

### 10.3 THEORIES OF ECONOMIC GROWTH

• The Basic Idea

• Advances in technology and the accumulation of capital bring increased productivity and increased real GDP per person.

• Classical growth theory says that the increase in real GDP per person will be temporary because prosperity will induce a population explosion and the population explosion will decrease real GDP per person.

### 10.3 THEORIES OF ECONOMIC GROWTH

• Classical Theory of Population Growth

• When the classical economists were developing their ideas about population growth, an unprecedented population explosion was under way.

• To explain the high rate of population growth, the classical economists used the idea of a subsistence real income (real GDP per person).

• In classical theory, when real income exceeds the subsistence real income, the population grows.

### 10.3 THEORIES OF ECONOMIC GROWTH

• The increasing population decreases capital per hour of labor and eventually decreases real income to less than subsistence real income.

• If the actual real income is less than the subsistence real income, some people cannot survive and the population decreases.

• No matter how much technological change occurs, real income (real GDP per person) is always pushed back toward the subsistence level.

• This dismal implication led to economics being called the dismal science.

### 10.3 THEORIES OF ECONOMIC GROWTH

Figure 10.3 shows classical growth theory.

1.The economy starts at point A on productivity curve PC0 with real GDP at the subsistence level and the population constant.

2. As capital per hour of labor increases, real GDP per person rises above the subsistence level—the economy moves to point B.

### 10.3 THEORIES OF ECONOMIC GROWTH

3. As technological advance (and human capital accumulate) increase productivity,the productivity curve shifts upward to PC1—the economy moves to C.

4. With real GDP above the subsistence level, the population grows and capital per hour of labor decreases downward along PC1.

### 10.3 THEORIES OF ECONOMIC GROWTH

5.At point D, the economy is back at the subsistence level of real GDP per hour of labor.

### 10.3 THEORIES OF ECONOMIC GROWTH

• Neoclassical Growth Theory

• Neoclassical growth theory

• The theory that real GDP per person will increase as long as technology keeps advancing.

• Neoclassical growth theory asserts that population growth and technological change influence but are not themselves influenced by real GDP growth.

• So according to the neoclassical theory, growth will persist.

### 10.3 THEORIES OF ECONOMIC GROWTH

• Population Growth

• Two opposing economic forces influence population growth.

• As incomes increase, the birth rate decreases and the death rate decreases.

• These opposing forces are offsetting, so the rate of population growth is independent of the rate of economic growth.

• The historical population trends contradict the views of the classical economists.

### 10.3 THEORIES OF ECONOMIC GROWTH

• Technological Change

• In the neoclassical theory, the rate of technological change influences the rate of economic growth, but economic growth does not influence the pace of technological change.

• It is assumed that technological change results from chance or something other than economic events, i.e. it is exogenous or autonomous – determined independently from the economic system.

### 10.3 THEORIES OF ECONOMIC GROWTH

• The Basic Idea

• Technological advances bring profit opportunities.

• Businesses expand and new businesses are created to exploit the new technologies.

• Investment and saving increase, so capital per hour of labor increases.

• The economy enjoys increased prosperity and growth.

### 10.3 THEORIES OF ECONOMIC GROWTH

• But will the prosperity last? And will the growth last?

• Neoclassical growth theory says that the prosperity will last but the growth will not unless technology keeps advancing.

• The prosperity persists because no population explosion occurs to lower real GDP per person.

### 10.3 THEORIES OF ECONOMIC GROWTH

• But growth stops if technology stops advancing because capital accumulation brings diminishing returns, which slow the growth rate of real GDP and slow the level of saving and investment.

• Eventually, the growth rate of capital slows to that of the population and real GDP per person stops growing.

• A Problem with Neoclassical Growth Theory

• The theory does not explain what determines technological change.

### 10.3 THEORIES OF ECONOMIC GROWTH

• New Growth Theory

• New growth theory

• The theory that our unlimited wants may lead us to ever greater productivity and perpetual economic growth.

• According to new growth theory, real GDP per person grows because of the choices people make in the pursuit of profit.

### 10.3 THEORIES OF ECONOMIC GROWTH

• Choices and Innovation

• The new theory of economic growth emphasizes three facts about market economies:

• Human capital grows because of choices.

• Discoveries result from choices.

• Discoveries bring profit, and competition destroys profit.

### 10.3 THEORIES OF ECONOMIC GROWTH

• Human Capital Growth and Choices

• People decide how long to remain in school, what to study, and how hard to study.

• Discoveries and Choices

• The pace at which new discoveries are made—and at which technology advances—is not determined wholly by chance.

• It also depends on how many people are looking for a new technology and how intensively they are looking.

### 10.3 THEORIES OF ECONOMIC GROWTH

• Discoveries and Profits

• The forces of competition squeeze profits, so to increase profit, people constantly seek either lower cost methods of production or new and better products for which people are willing to pay a higher price.

• Two other facts play a key role in the new growth theory:

• Many people can use discoveries at the same time – technical knowledge is potentially a ‘public good.’

• Physical activities can be replicated.

### 10.3 THEORIES OF ECONOMIC GROWTH

Figure 10.4 illustrates new growth theory in terms of a perpetual motion machine.

1.People want a higher standard of living and are spurred by...

2. Profit incentives to make the...

3. Innovations that lead to...

### 10.3 THEORIES OF ECONOMIC GROWTH

4.New and better techniques and new and better products,which in turn lead to...

5.The birth of new firms and the death of some old firms,

6.New and better jobs, and...

7.More leisure and more consumption goods and services.The result is...

### 10.3 THEORIES OF ECONOMIC GROWTH

8.A higher standard of living. But people want a yet higher standard of living, and the growth process continues.

### 10.3 THEORIES OF ECONOMIC GROWTH

• Productivity Curve and New Growth Theory

• Figure 10.5 illustrates new growth theory by using the productivity curve.

• According to this theory, capital increases and technology advances together may bring unending growth.

### 10.3 THEORIES OF ECONOMIC GROWTH

The economy starts out at point A on the productivity curve PC0.

An increase in capital per hour of labor brings a movement along the productivity curve PC0 and the expansion of human capital and technological change increase labor productivity and shift the productivity curve upward to PC1.

The economy moves to B.

### 10.3 THEORIES OF ECONOMIC GROWTH

The process repeats.

The economy moves to point C and then to points of yet greater capital per hour of labor and labor productivity.

### 10.3 THEORIES OF ECONOMIC GROWTH

• Growth in the Global Economy

• Classical growth theory predicts that the global economy will stagnate under the pressure of population growth.

• It also implies that the richest nations will be the ones with the fastest population growth and therefore they will be the first to stagnate.

• These predictions are resoundingly rejected by the experience of the world economy over the past few decades.

### 10.3 THEORIES OF ECONOMIC GROWTH

• Neoclassical growth theory predicts that the global economy will grow and at a rate that is determined by the pace of technological change.

• All economies have access to the same technologies, and capital is free to roam the globe seeking the highest available profits.

• So neoclassical theory predicts that national levels of real GDP/head and national growth rates will converge.

### 10.3 THEORIES OF ECONOMIC GROWTH

• There is some sign of convergence among the rich countries.

• But convergence is slow, and it does not appear to be imminent for all countries.

### 10.3 THEORIES OF ECONOMIC GROWTH

• New growth theory predicts that national growth rates depend on national incentives to save, invest, accumulate human capital, and innovate.

• Because these incentives depend on factors that are special to each country, national growth rates will not necessarily converge.

• Some real GDP gaps among rich countries and gaps between rich and poor countries might persist.

### 10.3 THEORIES OF ECONOMIC GROWTH

• Other gaps might close as poorer nations create better incentives to boost capital accumulation and technological change.

• New growth theory fits the facts more closely than do the other two theories. However, there are still many anomalies in terms of trying to explain why growth rates are different in different countries and in different time periods. Understanding how to improve growth performance is one of the great challenges still facing economists [and others].

### 10.4 ACHIEVING FASTER GROWTH

• Preconditions for Economic Growth

• Economic freedom is probably a fundamental precondition for creating the incentives that lead to economic growth in a market economy.

• Economic freedom

• A condition in which people are able to make personal choices, their private property is protected, and they are free to buy and sell in markets.

### 10.4 ACHIEVING FASTER GROWTH

• Economic freedom requires the protection of private property — the factors of production and goods that people own.

• Property rights

• The social arrangements that govern rights to use and dispose of property. Protection of private property implies that private individuals, households, and firms are able to own, use, and dispose of property within clearly defined parameters and rules. The nature of property rights vary substantially from place to place and time to time, and are rarely absolute.

• Economic freedom is usually defined to also require free markets.

### 10.4 ACHIEVING FASTER GROWTH

• Policies to Achieve Faster Growth

• To achieve faster economic growth, we must either:

• increase the growth rate of capital per hour of labor;

• or increase the growth rate of human capital;

• or increase the pace of technological advance;

• or improve our economic organization, management, or system.

### 10.4 ACHIEVING FASTER GROWTH

• The main actions that governments can take to achieve these objectives are:

• Create the incentive mechanisms

• Encourage saving

• Encourage research and development

• Encourage international openness

• Improve the quality of education

### 10.4 ACHIEVING FASTER GROWTH

• Create Incentive Mechanisms

• Economic growth occurs when the incentives to save, invest, and innovate are strong enough. These incentives require clear rules on property rights, and confidence in the rule of law – i.e. predictability.

• Encourage Saving

• Saving finances investment, which brings capital accumulation.

• Tax incentives can encourage saving, increase the growth of capital, and stimulate economic growth.

### 10.4 ACHIEVING FASTER GROWTH

• Research and Development

• The pace of technical change may be influenced by the volume of R&D activity; encouraging or funding R&D may accelerate growth, and is justifiable for “public good R&D”.

• International Openness

• Open borders for goods, people, and capital increase competition and thereby efficiency; and make the diffusion of new ideas and methods faster from their point of origin.

• Improve the Quality of Education

• By funding basic education and by ensuring high standards in skills such as language, mathematics, and science, governments can contribute enormously to a nation’s growth potential.

### 10.4 ACHIEVING FASTER GROWTH

• How Much Difference Can Policy Make?

• A well-intentioned government cannot dial up a big increase in the growth rate.

• But it can pursue policies that will nudge the growth rate upward.

• And over time, the benefits from these policies will be large.

• It is clear that ‘bad’ policies can stifle growth or even lead to negative growth.