1. 9
Economic Growth
CHAPTER CHECKLIST
When you have completed your study of this chapter, you will be able to
1 Define and calculate the economic growth rate, and explain the implications of sustained growth.
2 Identify the main the sources of economic growth.
3 Review the theories of economic growth that explain why growth rates vary over time and across countries.
4 Describe the policies that might speed economic growth.
Notes and teaching tips: 4, 5-6, 11, 53, and 54.
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2. 9.1 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 is the annual percentage change of real GDP.
Economic growth is an exciting topic for students.
Provide this table:
Year Average income
(2000 dollars per person per year)
,521
,000
,000
,100,000
The data for 1800 to 2000 are actual and the future data are hypothetical based on projecting the growth rate of the past 200 years a further 200 years into the future
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3. 9.1 THE BASICS OF ECONOMIC GROWTH
To calculate this growth rate, we use the formula:
Growth of real GDP =
Real GDP in current year
Real GDP in previous year
x 100 –
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
Ask your class what kind of life people had in the year 1800 with an average income of $762 a year in current dollars. Answers will vary but many students are likely to respond that life was quite hard. Transportation was limited to horses, and meals were all prepared at home from scratch and cooked over an open fire. Medical care was quite meager (even the stethoscope was sixteen years away in the making) and entertainment was limited to books and song. In fact, very few people actually owned a book besides the Bible in 1800! By 1900 life was a bit better. The advent of the railroad made transportation much more practical and efficient. The potbelly stove was now available to cook meals and we had even conquered a few diseases along the way.
Compare old jobs with the new by looking at the year 1900 versus today and the changes that have taken place with their development. Ask your students if they recognize the list of professions below. Make sure only to list the professions without the descriptions. Students will probably recognize a handful but there should be a good number that they have not heard of before. It makes for a great icebreaker when discussing how the economic landscape of the country has changed.
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Growth of real GDP =
$8.4 trillion – $8.0 trillion
$8.0 trillion
x 100
= 5 percent.

4. 9.1 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.
The contribution of real GDP growth to the change in the standard of living depends on the growth rate of real GDP per person.
Blacksmiths a person who works with iron
Wainrights a maker and repairer of wagons
Boilermakers a workman who makes, assembles or repairs boilers
Founders someone who melts and pours metal into molds
Coopers someone that makes or repairs wooden casks or tubs
Potters someone that makes pottery
Colliers a coal miner
Tinsmiths a worker who makes or repairs things of sheet metal
Millwrights someone who maintains and cares for mechanical equipment in a mill or factory
Virtually all of these professions are gone today. They’ve been replaced by mechanics, pilots, electricians, computer programmers, software designers, chemists, and engineers. You can ask your class what significant product developments occurred over the last 100 years that have been widely diffused throughout the economy. Here is a short list to get things going: radio, television, radar, tape recorder, computer, satellites, lasers, jet engine, nuclear power, robots, camcorders, cell phones, fiber‐optic cables, VCRs, and last but not least the Internet. The bottom line is that our economy has evolved from one that required mostly muscle when we were farmers to machines during the industrial age and finally to reliance on know‐how and creativity in the information age. The fruits of economic growth are higher product quality, less physical effort in producing goods and services, and larger amounts of leisure time.

5. 9.1 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.

6. 9.1 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 rate of real GDP per person
$41,584 – $40,000
$40,000
x 100
= 4 percent. =

7. 9.1 THE BASICS OF ECONOMIC GROWTH
The growth rate of real GDP per person can also be calculated by using the formula:
Growth of real GDP per person
Growth rate of real GDP
Growth rate of population – =
Growth of population
202 million – 200 million
200 million
x 100
= 1 percent. =

8. 9.1 THE BASICS OF ECONOMIC GROWTH
Growth of real GDP per person
5 percent – 1 percent
= 4 percent. =
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 real GDP, real GDP per person falls.

9. 9.1 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 is 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.
Ask the students if the economy will grow dramatically differently if the growth rate is 3 percent or 5 percent. Students will probably say that it won’t make much difference. But, counter that over longer periods of time it can make a substantial difference. You can demonstrate this fact with a few simple calculations. Assume a hypothetical economy that starts off with real GDP of $100 billion. The numbers in the table are the size of the economy in billions of dollars. What is instructive here is that small changes in the growth rate over short periods of time do not have much of an impact on the size of the economy. But small changes in growth rate over longer periods of time do. You can point out that the economy is almost at the same level at 5 percent growth after 10 years as it is at 3 percent after 20 years. In fact there is a very good historical example that you can point to that helps illustrate just how important small differences in economic growth can be. Since World War II the U.S. economy has grown at an average rate of approximately 3 percent a year. During the so‐called slow down of the 1970s the growth rate dropped by as much as half of its historical rate. Economists have estimated that this slow down has cost our economy at least three trillion dollars in lost output! You can explain that this is output that is irretrievably lost. That is, we cannot get it back.

10. 9.1 THE BASICS OF ECONOMIC GROWTH
Table 9.1 Growth Rates
Growth rate Years for level (% per year) to double Example
U.S. real GDP per person
China real GDP per person

11. 9.2 THE 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 and rate of increase in their productivity.
All the influences on real GDP growth can be divided into those that increase
Quantity of labor
Labor productivity

12. 9.2 THE SOURCES OF ECONOMIC GROWTH
Quantity of Labor
The quantity of labor is the number of labor hours available.
The quantity of labor equals the labor force multiplied by average hours per worker.
Average hours per worker have decreased.
But the labor force has grown at a fast enough pace to more than offset the fall in average hours per worker and bring a sustained increase in the quantity if labor.

13. 9.2 THE SOURCES OF ECONOMIC GROWTH
The labor force depends on the population and the labor force participation rate.
While the labor force participation rate has increased over the past few decades, it has an upper limit, so most of the growth in the quantity of labor comes from population growth.
That is, population growth is the only source of growth in the quantity of labor that can be sustained over long periods.

14. 9.2 THE SOURCES OF ECONOMIC GROWTH
Population growth brings economic growth, but it does not bring growth in real GDP per person unless labor becomes more productive.
Labor Productivity
Labor productivity is the quantity of real GDP produced by one hour of labor.
It is calculated by using the formula:
Real GDP
Labor productivity =
Quantity of labor hours

15. 9.2 THE SOURCES OF ECONOMIC GROWTH
For example, if real GDP is $8,000 billion and if the quantity of labor is 200 billion hours, then we can calculate labor productivity as
200 billion
Labor productivity =
$8,000 billion
= $40 per hour
You can turn this formula around and see that
Real GDP = Quantity of labor x Labor productivity

16. 9.2 THE 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.
The growth of labor productivity depends on three things:
Saving and investment in physical capital
Expansion of human capital
Discovery of new technologies

17. 9.2 THE SOURCES OF ECONOMIC GROWTH
Saving and Investment in Physical Capital
Saving and investment in physical capital increase the amount of capital per worker and 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

18. 9.2 THE SOURCES OF ECONOMIC GROWTH
Discovery of New Technologies
To reap the benefits of technological change, capital must increase.
Some of the most powerful and far-reaching technologies are embodied in human capital.
For example, language, writing, and mathematics.
But most technologies are embodied in physical capital.

19. 9.2 THE SOURCES OF ECONOMIC GROWTH
Sources of Growth: A Summary
Figure 9.1 shows the sources of real GDP growth.
Real GDP growth depends on quantity of labor growth and on labor productivity growth.

21. 9.2 THE SOURCES OF ECONOMIC GROWTH
Quantity of labor growth depends on
Population growth
The labor force participation rate
Average hours per worker

22. 9.2 THE SOURCES OF ECONOMIC GROWTH
Labor productivity growth depends on
Physical capital growth
Human capital growth
Technological advances

23. 9.4 ACHIEVING FASTER GROWTH
Preconditions for Economic Growth
Economic freedom is the fundamental precondition for creating the incentives that lead to economic growth.
Economic freedom is 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.
If you have technology available in your classroom, play a clip from one of the bands that played in the Live 8 concerts of July 2005 (for example, U2). Alternatively, play a clip of Bob Geldof or Bono (of U2) talking about the Live 8 concerts. Some of these can be found at the Live 8 website, (go to and scroll down to find film clips of Bono, Nelson Mandela, and others). Most students will recognize Bono and will be drawn in by music clips or photos of the concerts (photos can be found at This can lead to a discussion of the goal of Live 8 in trying to generate support for debt relief for poor nations before a meeting of the G8 countries (July 2005). Conduct a reality check with students that this is one of the big unanswered ‘questions’ in macroeconomics. There are a multitude of groups, individuals researchers, and governments trying to figure out how to help economies grow and to reduce poverty worldwide. Even the poorest of our students has little comprehension of what poverty truly is and what economic growth seeks to combat and can accomplish. You can give them a moving and in places shocking glimpse by asking them to “listen to the voices” at this World Bank Web page:
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24. 9.4 ACHIEVING FASTER GROWTH
Economic freedom requires the protection of private property—the factors of production and goods that people own.
Property rights are the social arrangements that govern the protection of private property.
Economic freedom also requires free markets.
The major obstacles to growth are political, and economists don’t know much about how to remove those political obstacles. You can give your students a glimpse of these obstacles in their worst form by reminding them of news video clips they’ve almost certainly seen of Kabul, Mogadishu, and other troubled cities in which the rule of law has completely broken down. Economists know a lot about how to make an economy grow if the preconditions are in place, but virtually nothing about how to bring those preconditions about.
The three preconditions for growth—markets, property rights, and monetary exchange are all essential to create acceptable levels of risk and low enough transactions costs to justify investment, specialization, and exchange. If you want to spend time on it, you can generate an interesting discussion on whether what matters is the particular system of property rights, or just that they be clear, certain, and enforceable with reasonable cost—the concept of the rule of law. Most students have never realized that property rights are highly varied, and many fast growing economies have nothing like U.S. absolute property rights in land, for example.
Most students can see immediately how investment in physical and human capital in the form of education and training contribute to growth. Some have more difficulty getting a clear view of the role of learning by doing and technical change, particularly the small continuous refinement and improvement to existing technology rather than the spectacular breakthroughs. Much growth probably comes from the interaction of the last two, and this source of growth can be illustrated with a discussion of why firms offer incentives to workers to suggest improvements to working methods and procedures.

25. 9.4 ACHIEVING FASTER GROWTH
Policies to Achieve Faster Growth
To achieve faster economic growth, we must increase
The growth rate of capital per hour of labor or
The growth rate of human capital or
The pace of technological advance.

26. 9.4 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 trade
Improve the quality of education

27. 9.4 ACHIEVING FASTER GROWTH
Create Incentive Mechanisms
Economic growth occurs when the incentive to save, invest, and innovate is strong enough. These incentives exist only when private property is protected.
Encourage Saving
Saving finances investment, which brings capital accumulation.
Tax incentives can encourage saving, increase the growth of capital, and stimulate economic growth.

28. 9.4 ACHIEVING FASTER GROWTH
Encourage Research and Development
Everyone can use the fruits of basic research and development efforts.
Because basic inventions can be copied, the inventor’s profit is limited and so the market allocates too few resources to this activity.
Governments can direct public funds toward financing basic research, but it requires a mechanism for allocating public funds to their highest-valued use.

29. 9.4 ACHIEVING FASTER GROWTH
Encourage International Trade
Free international trade stimulates economic growth by extracting all the available gains from specialization and trade.
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.

30. 9.4 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.