Economic Growth: Theory and Policy Chapter 7 Economic Growth: Theory and Policy Once one starts to think about . . . [differences in growth rates among countries], it is hard to think about anything else. ROBERT E. LUCAS, JR.

Three Pillars of Productivity Growth Growth policy High sustainable long-run growth Potential GDP Represented by production function Y=zF(K,L) Stabilization policy Keep actual GDP Close to potential GDP - short run No high unemployment No high inflation

Three Pillars of Productivity Growth Labor productivity grows: Larger capital stock (K↑) Given technology & labor force Better technology (z↑) Given capital & labor Workforce quality (L↑) More education & training Given capital, technology, labor force Human capital (education & training) Amount of skill embodied in workforce Labor (L) = number of worker (N) * H

Figure 1 Production functions corresponding to three different capital stocks Output K3 c Yc K2 b Yb K1 a Ya L1 Hours of Labor Input

Levels, Growth Rates, & Convergence Level of productivity Higher in rich countries Depends on Supply of human & physical capital State of technology Growth rate of productivity Depends on growth rates of Capital (K) Workforce skills (H) Technology (z)

Table 1 Productivity levels and productivity growth rates in selected countries Country GDP per hour of work 1980 (as percentage of U.S.) GDP per hour of work 2005 Growth rate United States France United Kingdom Spain Ireland Argentina Mexico Brazil South Korea 100 86 71 62 57 51 44 33 20 99 85 96 37 25 23 48 1.7 2.3 2.4 3.9 0.4 -0.5 0.2 5.4

Levels, Growth Rates, & Convergence Convergence hypothesis Nations with low levels of productivity High productivity growth rates International productivity differences Shrink over time Poorer countries Higher productivity growth

Figure 2 The Convergence Hypothesis Richer country Poorer country Real GDP per capita $10,000 Richer country $2,000 Poorer country Time

Levels, Growth Rates, & Convergence Technological laggards Can close the income gap Imitation, not innovation Adopt existing technologies Example: Boeing 767 in domestic airline, cell phone and internet access in China “Convergence club” Productivity growth rates - higher Where productivity levels are lower (South Korea, China, India, Ireland, …) Poorest nations Unable to join

GDP per capita growth rate, Table 2 Levels and growth rates of GDP per capita in selected poor countries Country GDP per capita 2005* GDP per capita growth rate, 1990-2005 Belarus Russia Ukraine Peru Haiti Burundi Sierra Leone $1,868 2,445 960 2,337 434 105 218 2.0% -0.4 -2.4 2.3 -2.5 -0.9 *in constant 2000 U.S. dollars

Growth Policy: Capital Formation Nation’s capital Available supply Plant, equipment, software Result of past decisions – investments Investment Flow of resources Production of new capital Inputs Construction of capital Period of time

Growth Policy: Capital Formation Investment Process of building up capital stock Trade-off More capital formation Quicker growth Consume less today More consumption today Less capital formation Slower growth

Figure 3 Choosing between investment and consumption A Investment Goods Produced A I C D Consumer Goods Produced

Growth Policy: Capital Formation Speed up capital formation / investment Lower real interest rates Tax provisions Technical change Growth of demand Political stability Property rights Laws and/or conventions Owners - rights to use their property

Table 3 Selected countries ranked by level of investor protection Country Rating (0-10 scale) Singapore United States Canada United Kingdom Japan Mexico India Sweden Brazil Italy China Swaziland 9.3 8.3 8.0 7.0 6.0 5.7 5.3 5.0 2.3

Growth Policy: Education & Training More-educated & better-trained workers Higher productivity Higher wages Education policy Improve quality of education Earning gap High school graduates College graduates On-the-job-training Skills acquired at work

Figure 4 Wage premium for college graduates over high school graduates

Growth Policy: Technological Change Advancement of technology More education Scientific, engineering, managerial More capital formation Research & development (R&D) Inventing new products/processes Improving existing ones R&D – encouraged by government Tax credit Collaborative research Spending on R&D

Productivity Slowdown & Speed-up, U.S. 1948-1973: 2.8% 1973-1995 Productivity slowdown, 1.4% Lagging investment High energy prices Inadequate workforce skills Not: technological slowdown

Figure 5 Average productivity growth rates in the United States, 1948–2007

Productivity Slowdown & Speed-up, U.S. 1995-2007 Productivity speed-up, 2.5% IT revolution Surging investment Falling energy prices Advances in information technology

Growth in the Developing Countries Poorly endowed with capital Difficult to accumulate capital Development assistance – foreign aid Outright grants & Low-interest loans From rich countries & multinational institutions To spur economic development

Growth in the Developing Countries Foreign direct investment Purchase/construction Real business assets Multinational corporations Low level of technology Low levels of education & training Poor geographical conditions Poor health Governance

Table 4 Average educational attainment in selected countries, 2000 United States Canada South Korea Japan United Kingdom Italy Mexico India Brazil Sudan 12.3 11.4 10.5 9.7 9.4 7.0 6.7 4.8 4.6 1.9 For people older than 25 years of age

From the Long Run to the Short Run Over long periods of time Similar growth rates Actual GDP Potential GDP Macroeconomic fluctuations GDP shrinks – recessions Needed: a short-run theory of AD (next chapter)

Summary Source of economic growth (K, z, and H) Convergence hypothesis Growth policy Capital formation Improve education and training Spur technical change Productivity slowdown and speed-up Growth in the developing countries