McGraw-Hill/Irwin © 2009 The McGraw-Hill Companies, All Rights Reserved Chapter 7 Economic Growth

7-2 © The McGraw-Hill Companies, Inc., 2009 McGraw-Hill/Irwin LO The Economy in the Long Run Economic Growth Saving and Capital Formation Money and Prices

7-3 © The McGraw-Hill Companies, Inc., 2009 McGraw-Hill/Irwin LO 19- All Learning Objectives 1.Show how small differences in growth rates lead to large differences in living standards 2.Explain why GDP per capita is average labor productivity times the proportion of the population employed  Use this to discuss the sources of growth 3.Discuss the determinants of average labor productivity 4.Understand the trade-offs between economic growth and environmental quality

7-4 © The McGraw-Hill Companies, Inc., 2009 McGraw-Hill/Irwin LO 19- All Benefits of Growth  In the late 18 th and early 19 th century  Life expectancy was 40 years  Most families had 2 or 3 children die  Nothing moved faster than the speed of a horse  The best highway was from Boston to New York  A stagecoach made the 175-mile trip in 3 days  Pace of technical change is accelerating  Inventions are not sufficient to create growth  Products must be commercialized and sold

7-5 © The McGraw-Hill Companies, Inc., 2009 McGraw-Hill/Irwin LO Real GDP per Person, (in 2000 US Dollars)

7-6 © The McGraw-Hill Companies, Inc., 2009 McGraw-Hill/Irwin LO Real GDP per Capita, Country US $2,936$6,366$11,484$22,567$34,875 UK 3,8996,0148,48116,09326,046 Germany 2,4202,8005,10618,41125,188 Japan 8351,5712,17614,91224,037 Brazil ,1656,3367,205 China ,0764,970 Ghana ,1871,2811,440

7-7 © The McGraw-Hill Companies, Inc., 2009 McGraw-Hill/Irwin LO Growth of Real GDP per Capita, Country Annual % Change 1870 – 2003 Annual % Change 1950 – 2003 Annual % Change US1.9%2.1%1.8% UK Germany Japan Brazil China Ghana

7-8 © The McGraw-Hill Companies, Inc., 2009 McGraw-Hill/Irwin LO Compound Interest Rates  In 1870, Brazil's GDP per capita was twice Ghana's  By 2003, the multiple increased to 5 times  Brazil's growth over the period was 1.6% and Ghana's was 0.9%  Compound interest pays interest on the original deposit and all previously accumulated interest  Interest paid in year 1 earns interest in year 2  $10 deposited at 4% interest in 1800 is $31, in 2005  $10 x (1.04) 205 = $31,033.77

7-9 © The McGraw-Hill Companies, Inc., 2009 McGraw-Hill/Irwin LO Compound Interest  Differences in interest rates matter  Growth rates in GDP per capita have the same effect as interest rates  Relatively small growth in GDP per capita has a very large effect over a long period  In the long run, the growth rate of an economy matters Interest Rate (%)Value of $10 after 205 years 2$ $31, $1,540,644.29

7-10 © The McGraw-Hill Companies, Inc., 2009 McGraw-Hill/Irwin LO Real GDP per Capita  Notation  Y = real GDP  N = number of people employed  POP = population  GDP per capita is the product of output per worker and the share of population employed  Consumption per person depends on  How much each worker produces and  The share of people working

7-11 © The McGraw-Hill Companies, Inc., 2009 McGraw-Hill/Irwin LO Understanding Growth  GDP per capita increases when  Output per worker (Y / N) increases OR  The share of the population employed (N / POP) increases  Between 1960 and 2007,  GDP per capita increased 172%  Output per worker increased 110%  The share of the population employed increased from 36% to 48%  Baby boomers in their working age  Increasing female labor force participation

7-12 © The McGraw-Hill Companies, Inc., 2009 McGraw-Hill/Irwin LO Y / POP and Y / N,

7-13 © The McGraw-Hill Companies, Inc., 2009 McGraw-Hill/Irwin LO N / POP,

7-14 © The McGraw-Hill Companies, Inc., 2009 McGraw-Hill/Irwin LO Understanding Growth The rising share of the population employed is transitory. In the long run, increases in output per person arise primarily from increases in average labor productivity (output per worker).

7-15 © The McGraw-Hill Companies, Inc., 2009 McGraw-Hill/Irwin LO Average Labor Productivity  US average labor productivity is  24 times Indonesia's  100 times Bangladesh's  Six factors determine average labor productivity 1.Human capital 2.Physical capital 3.Land and other natural resources 4.Technology 5.Entrepreneurship and management 6.Political and legal environment

7-16 © The McGraw-Hill Companies, Inc., 2009 McGraw-Hill/Irwin LO Physical Capital  More and better capital increases worker productivity  Factory owner employs two people and adds capital  Each machine requires one dedicated operator  More capital increases output per hour  Diminishing returns to capital Number of Machines Output per Week Hours Worked per Week Output per Hour Worked 016, , , ,

7-17 © The McGraw-Hill Companies, Inc., 2009 McGraw-Hill/Irwin LO Diminishing Returns to Capital  Diminishing returns to capital occurs if an addition of capital with other inputs held constant increases output by less than the previous increment of capital  Assumption: all inputs except capital are held constant  Result: output increases at a decreasing rate  When a firm has many machines, the most productive uses have already been filled  The increment in capital will necessarily be assigned to a less productive use than the previous increment  Principle of Increasing Opportunity Cost

7-18 © The McGraw-Hill Companies, Inc., 2009 McGraw-Hill/Irwin LO Growth and Diminishing Returns to Capital  Implications of diminishing returns  Increasing capital will increase output and labor productivity  Positive contribution to growth  There are limits to increasing productivity by adding capital because of diminishing returns

7-19 © The McGraw-Hill Companies, Inc., 2009 McGraw-Hill/Irwin LO Capital and Output per Worker, 1990 Low capital/worker, Low GDP per worker High capital/worker, High GDP per worker

7-20 © The McGraw-Hill Companies, Inc., 2009 McGraw-Hill/Irwin LO Trade-offs between economic growth and environment  Research indicates that pollution increases up to a point with increased GDP per person  After A, air pollution decreases and air quality improves  Estimates suggest Mexico is close to point A  Beyond a certain level of income, citizens value a cleaner environment and they are willing and able to pay for it Real GDP per capita Air pollution A