Economic Growth and Rising Living Standards

1. Economic Growth and Rising Living Standards

2. Economic Growth and Rising Living Standards • Economist Thomas Malthus, writing in 1798, came to a striking conclusion • “Population, when unchecked, goes on doubling itself every twenty-five years, or increases in a geometrical ratio…The means of subsistence…could not possibly be made to increase faster than in an arithmetic ratio” • Prognosis was so pessimistic that it led Thomas Carlyle, one of Malthus’s contemporaries, to label economics “the dismal science” • History has proven Malthus wrong…at least in part • Economists today are optimistic about industrialized nations’ long-run material prospects • Achieving a higher rate of growth in long-run generally requires some sacrifice in short-run

3. The Importance of Growth • Why should we be concerned about economic growth? • When output grows faster than population, GDP per capita will rise • When output grows more slowly than population, average standard of living will fall • Measuring standard of living by GDP per capita may seem limiting • Still, many aspects of our quality of life are counted in GDP such as • Food, housing, medical care, education, transportation services, and movies and video games • Economic growth is especially important in countries with income levels far below those of Europe, Japan, and United States • Other than emigration, economic growth is their only hope • Growth is a high priority in prosperous nations, too • When output per capita is growing, it’s at least possible for everyone to enjoy an increase in material well-being without having to cut back

4. The Importance of Growth • When output per capita stagnates, material gains become a fight over a fixed pie • The more purchasing power my neighbor has, the less is left for me • In 1950s and 1960s, economic growth in wealthier nations seemed to be taking care of itself • All of that changed starting in 1970s • Economic growth became a national and international preoccupation • Over most of postwar period, output in more prosperous industrialized countries grew by 2 or 3% per year • Beginning in mid-1970s, all of these nations saw their growth rates slip • In late 1990s and early 2000s, only United States and United Kingdom returned to their previous high rates of growth • Other industrialized countries continued to grow more slowly than their historical averages • Seemingly small differences in growth rates matter a great deal

5. What Makes Economies Grow? • Useful way to start thinking about long-run growth • Look at what determines our potential GDP in any given period • Real GDP depends on • Amount of output average worker can produce in an hour • Number of hours average worker spends at the job • Fraction of population that wants to work • Size of population • Amount of output the average worker produces in an hour is called labor productivity, or productivity • Measured by taking total output (real GDP) of economy over a period of time and dividing by total number of hours that everyone worked during the period to produce that output • Productivity = Output per hour = Total output ÷ Total hours worked

6. What Makes Economies Grow? • Hours of the average worker can be found by dividing total hours worked over a period by total employment, number of people who worked during the period • Average Hours = Total hours worked ÷ Labor Force • Fraction of population working is labor force participation rate (LFPR) • Found by dividing labor force (all those who want to work) by population • LFPR = Labor Force ÷ Population

7. What Makes Economies Grow? • Multiply these variables together • Total output = Total output ÷ Total hours worked x Total hours worked ÷ Labor Force x Labor Force ÷ Population x Population • Can write equation for total output as • Total output = Productivity x Average Hours x LFPR x Population • Over long-run, when total output tracks closely with potential output, this will give us an equation for potential output

8. What Makes Economies Grow? • Mathematics states that if two variables A and B are multiplied together • Percentage change in their product is approximately equal to sum of their percentage changes • % Δ (A x B) ≈ % ΔA + % ΔB • Applying this rule to all four variables in right side of our equation, as well as to total output on left • Find that growth rate of output (% Δ Total Output) over any period of time is • % Δ Total Output ≈ % Δ productivity + % Δ average hours + % Δ LFPR + % Δ Population

9. Economic Growth and Living Standards • Ultimately, growth in potential output does not by itself account for a rise in living standards • What matters for a rising standard of living is real GDP per capita • Which—over long-run—will equal our potential output divided by population • Total output = Productivity x Average Hours x LFPR x Population • If we divide both sides by the population, we get • Total output ÷ Population = Productivity x Average Hours x LFPR • In terms of percentage growth rates • % Δ Output per person ≈ % Δ Productivity + % Δ Average hours + % Δ LFPR • Notice that population drops out of the equation • Only way to raise living standards is to increase productivity, average hours, or labor force participation rate

10. Economic Growth and Living Standards • If output per person grew due to growth in average work hours, it’s not clear that living standard would increase • In most developed countries, average hours are slowly decreasing, not increasing • So our last simplification is to ignore changes in average hours in growth equation • % Δ Output per person ≈ % Δ productivity + % Δ LFPR • To explain why U.S.—or any developed country—has enjoyed continual rises in living standards over long periods of time • Must look to growth in productivity and growth in labor force participation rate

11. Growth in the Labor Force Participation Rate (LFPR) • With a constant population, any policy that increases total number of workers in economy will, by definition, increase labor force participation rate • Over past 50 years, as labor supply curve has shifted rightward, labor demand curve has shifted rightward as well • Why? • Changes have increased amount of output a worker can produce in any given period • So firms have wanted to hire more of them at any wage • Over past century, increases in labor demand have outpaced increases in labor supply • So that, on balance, average wage has risen and employment has increased

12. Growth in the Labor Force Participation Rate (LFPR) • Impact of these changes on total employment has been dramatic • Currently, U.S. Bureau of Labor Statistics predicts employment growth of 1% per year until 2010—about the same as growth rate of population • Is there anything we can do to make it grow over the next several years, and thus increase our rate of economic growth? • Yes • But, keep in mind that these measures to increase employment would also have costs • Costs that Americans may or may not be willing to pay

13. Figure 1: An Increase in Labor Supply

14. Figure 2: An Increase in Labor Demand

15. S L Real 2 Hourly S Wage L 1 B W 2 W D 1 L 2 A D L 1 L 2 Millions L 1 of Workers Figure 3: The U.S. Labor Market Over A Century

16. How To Increase Employment and the LFPR • One set of policies to increase employment focuses on changing labor supply • An often-proposed example of this type of policy is a decrease in income tax rates • Tax cut would be just what was needed to get you to seek work • When we extend your reaction to population as a whole • Can see that a cut in income tax rate can convince more people to seek jobs at any given wage • Shifting labor supply curve rightward • Many American workers must pay combined federal, state, and local taxes of more than 40¢ out of each additional dollar they earn • This may be discouraging work effort in United States • In addition to tax rate changes, some economists have advocated changes in government transfer programs to speed growth in employment • Redesigning these programs might stimulate growth in labor supply • This reasoning was an important motive behind the sweeping reforms in U.S. welfare system in August 1996

17. How To Increase Employment and the LFPR • A cut in tax rates increases reward for working • While a cut in benefits to the needy increases hardship of not working • Either policy can cause a greater rightward shift in the economy’s labor supply curve than would otherwise occur and create growth in labor force participation and output • Government policies can also affect labor demand curve • Government policies that help increase skills of the workforce or that subsidize employment more directly shift the economy’s labor demand curve to the right • Increasing employment and output

18. How To Increase Employment and the LFPR • Efforts to create growth in labor force participation are controversial • In recent decades, those who prefer an activist government have favored policies to increase labor demand • Through government-sponsored training programs, more aid to college students, employment subsidies to firms, etc. • Those who prefer a more laissez-faire approach have generally favored policies to increase labor supply by decreasing government involvement • Lower taxes or a less generous social safety net

19. Employment Growth: LFPR vs. Population • Increases in employment have been an important source of economic growth in United States and many other countries • Has been almost entirely due to increases in population, rather than increases in labor force participation • Labor force participation rate did account for growth in living standards during 1970s and 1980s as women—especially married women—entered labor force at much higher rates than previously • But by 1990, this source of growth in living standards was exhausted • LFPR did not rise during 1990s and is not projected to rise in near future • Efforts to increase living standards by raising LFPR have two serious drawbacks • LFPR cannot create rapid growth in living standards indefinitely, because there is a logical upper limit of 100% • In developed economies, raising LFPR means that people who currently do not want jobs must change their minds and want to work

20. Growth in Productivity • We eliminated variables that could not explain rising living standards over long-run • Ruled out population growth • Based on logic of equation for total output per person • Ruled out growth in average hours • Because of upper limit on this variable’s growth and high opportunity cost paid to raise hours per worker when most of labor force is already working full-time • Ruled out increases in labor force participation • At least as a source of continual, rapid economic growth • Only one variable remains • Productivity • Can we do anything to make productivity grow even faster?

21. Figure 4: Capital Accumulation and Labor Productivity

22. Growth in the Capital Stock • One key to productivity growth is growth in nation’s capital stock • Amount of capital available for average worker • With more capital a given number of workers can produce more output than before • Since same number of workers are working same number of hours, but producing more output than before, productivity rises • Growth in capital stock will increase productivity as long as it increases amount of capital per worker • If capital stock grows faster than labor force then capital per worker will rise • Labor productivity will increase along with it • But if capital stock grows more slowly than labor force, then capital per worker will fall • Labor productivity will fall as well

23. Investment and the Capital Stock • An increase in capital stock plays a central role in economists’ thinking about growth • Contributes to a rise in labor productivity and helps to raise living standards • A stock variable measures a quantity at a moment in time • Capital stock is a measure of total plant and equipment in economy at any moment • Planned investment is a flow variable • Measures a process that takes place over a period of time • As long as investment is greater than depreciation, total stock of capital will rise • The greater the flow of investment, the faster will be the rise in capital stock

24. Targeting Businesses: Increasing the Incentive to Invest • One kind of policy to increase investment targets the business sector itself • With goal of increasing planned investment spending • Corporate profits tax • Tax on profits earned by corporations • Investment tax credit • A reduction in taxes for firms that invest in certain favored types of capital • Reducing business taxes or providing specific investment incentives can shift the investment curve rightward • Speeding growth in physical capital • Increasing growth rate of living standards

25. Figure 5: An Increase In Investment Spending

26. Targeting Households: Increasing the Incentive to Save • While firms make decisions to purchase new capital, it is largely households that supply firms with funds, via personal saving • An increase in investment spending can originate in household sector, through an increase in desire to save • If households decide to save more of their incomes at any given interest rate • Supply of funds curve will shift rightward • What might cause households to increase their saving? • Greater uncertainty about economic future • Increase in life expectancy • Anticipation of an earlier retirement • Change in tastes toward big-ticket items • Change in attitude about saving • Any of these changes—if they occurred in many households simultaneously—would shift saving curve to the right • But government policy can increase household saving as well • One often-proposed idea is to decrease capital gains tax

27. Targeting Households: Increasing the Incentive to Save • Another frequently proposed measure is to switch from current U.S. income tax • Taxes all income whether it is spent or saved • To a consumption tax • Would tax only the income that households spend • Another proposal to increase household saving is to restructure U.S. Social Security system • Provides support for retired workers who have contributed funds to system during their working years • Government can alter tax and transfer system to increase incentives for saving • If successful, these policies would • Make more funds available for investment • Speed growth in capital stock • Speed rise in living standards

28. Figure 6: An Increase In Savings

29. Interest Supply E Rate of Funds (Saving) A 5% B 3% Investment Spending Investment 1.0 1.5 Spending + Deficit 1.75 Funds ($ Trillions) Figure 7: Deficit Reduction and Investment Spending

30. Shrinking the Government’s Budget • A final pro-investment measure is directed at government sector itself • A decrease in government purchases results in • Raising consumption and investment • Link between government budget, interest rate, and investment spending is major reason why U.S. government, and governments around the world, try to reduce and, if possible, eliminate budget deficits • Shrinking deficit or rising surplus tends to reduce interest rates and increase investment • Speeding growth in capital stock • In 1990s, Congress set strict limits on growth of government spending • Budget deficit began shrinking

31. Shrinking the Government’s Budget • When George W. Bush took office in 2001, direction of growth policy shifted away from preserving budget surpluses and toward lower tax rates • A second tax cut in 2003—amounting to $350 billion over 10 years—increased current and project deficits further • Tax cuts included some elements to increase investment spending • Such as a lower tax rate for capital gains and tax incentives for investment by small businesses • But the tax cuts • By raising current and future budget deficits would increase interest rates • Worked in opposition to the growth benefits of tax cut

32. An Important Proviso About the Government Budget • A reduction in the deficit or an increase in the surplus—even if they stimulate private investment—are not necessarily pro-growth measures • Depends on how the budget changes • The answers can make a big difference to the impact on growth • Government investment in new capital and in maintenance of existing capital makes an important contribution to economic growth • Impact of deficit reduction on economic growth depends on which government programs are cut • Shrinking deficit by cutting government investment will not stimulate growth as much as would cutting other types of government spending

33. Human Capital and Economic Growth • Human capital • Skills and knowledge possessed by workers • An increase in human capital works like an increase in physical capital to increase output • Causes production function to shift upward • Raises productivity and increases average standard of living • Another similarity between human and physical capital • Both are stocks that are increased by flows of investment • Human capital investments are made by business firms, by government, and by households • Human capital, unlike physical capital, cannot be separated from the person who provides it • Many pro-growth policies discussed earlier are also effective in promoting investment in human capital • Policies that increase employment or increase investment in physical capital

34. Technological Change • Another source of growth is technological change • Invention or discovery of new inputs, new outputs, or new methods of production • New technology affects economy in much the same way as do increases in capital stock • Shifts production function upward • Since it enables any given number of workers to produce more output • In many cases, new technology requires acquisition of physical and human capital before it can be used • In some instances, however, a new technology can be used without any additional equipment or training • As when a factory manager discovers a more efficient way to organize workers on the factory floor • The faster the rate of technological change • The greater the growth rate of productivity, and • The faster the rise in living standards

35. Technological Change • Might seem that technological change is one of those things that just happens • But pace of technological change is not as haphazard as it seems • Rate of technological change in economy depends largely on firms’ total spending on R&D • Policies that increase R&D spending will increase pace of technological change • What can government do to increase spending on R&D? • Can increase its own direct support for R&D by carrying out more research in its own laboratories or increasing funding for universities and tax incentives to private research labs • Can enhance patent protection • Increases rewards for those who create new technology by giving them exclusive rights to use it or sell it • Encourages developers to spend more on R&D • R&D spending is in many ways just like other types of investment spending • Funds are drawn from the financial market, and R&D programs require firms to buy something now (laboratories, the services of research scientists, materials to build prototypes) for uncertain prospect of future profits

36. The Cost of Economic Growth • Why don’t all nations pursue these policies and push their rates of economic growth to the maximum? • Promoting economic growth involves unavoidable trade offs • Requires some groups, or nation as a whole, to give up something else that is valued • In order to decide how fast we want our economy to grow we must consider growth’s costs as well as benefits • One of the most important things you will learn in your introductory economics course is that there are no costless solutions to society’s problems • What are the costs of growth?

37. Budgetary Costs • Cutting income tax rate • Cutting taxes on capital gains or corporate profits • Cutting taxes on saving • Implementing any of these tax cuts would force the government to choose among three unpleasant alternatives • Increase some other tax to regain lost revenue, cut government spending, or permit budget deficit to rise • While properly targeted tax cuts can increase rate of economic growth • Will force us to either redistribute tax burden or cut government programs

38. Consumption Costs • Any pro-growth policy that works by increasing investment—private or government, in physical capital, human capital, or R&D—requires a sacrifice of current consumption spending • Role of this trade-off in economic growth can be clearly seen with production possibilities frontier (PPF) • Greater investment in physical capital, human capital, or R&D will lead to faster economic growth and higher living standards in the future • But we will have fewer consumer goods to enjoy in the present

39. Production of Capital D Goods E K B A C Production of Consumption Goods Figure 8: Consumption, Investment, and Economic Growth

40. Opportunity Costs of Workers’ Time • Living standards will also rise if a greater fraction of population works or if those who already have jobs begin working longer hours • But this increase in living standards comes at a cost • Decrease in time spent in nonmarket activities • Thus, when economic growth comes about from increases in the labor force participation rate (or in average hours), we face a trade-off • Can enjoy higher incomes and more goods and services • Will have less time to do things other than work in the market

41. Sacrifice of Other Social Goals • Rapid economic growth is an important social goal, but not the only goal • Some policies that quicken the pace of growth require us to sacrifice other goals that we care about • But, just as government policies to stimulate investment require us to sacrifice other goals, so, too, can pursuit of other goals impede investment spending and economic growth • We can achieve greater worker safety, a cleaner environment, and other social goals, but we may have to sacrifice some economic growth along the way • Alternatively, we can achieve greater economic growth, but we will have to compromise on other things we care about

42. Using the Theory: Economic Growth in the Less-Developed Countries • In most countries, Malthus’s dire predictions have not come true • Less-developed countries (LDCs) • How does a nation go about increasing its capital stock? • Shifting resources away from consumer-goods production toward capital-goods production • Some countries that were once LDCs have applied the formula very effectively • But other LDCs have had great difficulty raising living standards • Much of the explanation for low growth rates of many LDCs lies with three characteristics that they share • Very low current output per capita • High population growth rates • Poor infrastructure

43. Using the Theory: Economic Growth in the Less-Developed Countries • These characteristics interact to create a vicious circle of continuing poverty • Which we can understand with the help of the familiar PPF between capital goods and consumption goods • In order to have rising capital per worker—an important source of growth in productivity and living standards • A nation’s stock of capital must not only grow, but grow faster than its population • Poorest LDCs are too poor to take advantage of the trade-off between consumption and capital production in order to increase their living standards • Since they cannot reduce consumption below current levels, they cannot produce enough capital to keep up with their rising population • In recent history, countries have attempted several methods to break out of this vicious circle of poverty • During 1930s, dictator Joseph Stalin simply forced Soviet economy from a point like H to one like J in Figure 9 • Millions who complained too loudly, or who otherwise represented a political threat, were rounded up and executed

44. Using the Theory: Economic Growth in the Less-Developed Countries • A less-brutal solution to problem of LDCs is to make wealthy bear more of the burden of increasing growth • These moves often backfire in long-run • Since restrictions on personal and economic freedom are remembered long after they are removed • Makes the public—especially foreigners—hesitant to invest in that country • A third alternative—and the one used increasingly since 1940s—is foreign investment or foreign assistance • Variation on this strategy • Foreign nations provide consumer goods so that poorer nation can shift its own resources out of producing them (and into capital production) without causing consumption levels to fall • Another alternative is slowing growth in population • Has been an important (and successful) part of China’s growth strategy • Although it has required severe restrictions on rights of individual families to have children

45. Figure 9: LDC Growth and Living Standards

46. (b) (a) Production Production of Capital of Capital Goods Goods K K F H T N N ´ N S C S C Production Production of Consumption of Consumption Goods Goods Figure 10: Growth Options for LDCs