Long-Run Economic Growth

Long-Run Economic Growth Potential GDP: The level of GDP attained when all firms are producing at capacity. Business cycle: Alternating periods of economic expansion and economic recession.

Comparing Economies Economists measure growth using Real GDP and perhaps more importantly Real GDP per capita (GDP per person). Real GDP per capita is five times the 1929 level, and 7 times the 1900 level

Example: Compare across countries Country 2007 Real GDP (billions) 2008 Real GDP (billions) Brazil $1,295.7 $1,362.6 Mexico $8,806.7 $8,911.4 Thailand $4,259.5 $4,368.4 Question: What country experienced the highest growth rate in 2008? The lowest?

Example: Country A Year Real GDP per capita (2005 prices) 2006 $41,552 2007 $42,680 2008 $42,202 2009 $43,194 2010 $43,102 What is the % increase in real GDP per capita between 2006 and 2010? What is the average annual real GDP per capita growth rate between 2006 and 2010?

Over the past century, U. S Over the past century, U.S. real GDP per capita rose by nearly 600%, representing an average annual growth rate of real GDP per capita of 1.9% since 1900. Despite recent increases in growth, China and India are still poorer than the United States was in 1900. Source: 1900–2001 data: Angus Maddison, The World Economy: Historical Statistics (Paris: OECD, 2003); 2002–2003 data: World Bank.

Long-Run Economic Growth Long-run economic growth: The process by which rising productivity increases the average standard of living.

Growth Rates How did the United States produce seven times more real GDP per capita in 2000 than in 1900? A little bit at a time – power of compounding! Long-run economic growth is normally a gradual process, in which real GDP per capita grows at most a few percent per year. During the twentieth century, real GDP per capita in the United States increased an average of 1.9% each year.

Small Differences in Growth Rates Are Important In the long run, small differences in economic growth rates result in big differences in living standards. Why Do Growth Rates Matter? Growth rates matter because an economy that grows too slowly fails to raise living standards.

Rule of 70 During the twentieth century, real GDP per capita in the United States increased an average of 1.9% each year. The years it takes for a variable that grows gradually to double is approximately: If real GDP per capita grows at 1% per year, it will take 70 years to double. If it grows at 2% per year, it will take only 35 years to double. In fact, U.S. real GDP per capita rose on average 1.9% per year over the last century. Applying the Rule of 70 to this information implies that it should have taken 37 years for real GDP per capita to double; it would have taken 111 years—three periods of 37 years each—for U.S. real GDP per capita to double three times. That is, the Rule of 70 implies that over the course of 111 years U.S. real GDP per capita should have increased by a factor of 2 × 2 × 2 = 8. And this does turn out to be a pretty good approximation to reality, once we adjust for the fact that a century is a bit less than 111 years. During the twentieth century, U.S. real GDP per capita rose seven-fold, a bit less than eight-fold.

Rule of 70 So at 1.9% growth, how long does it take real GDP per capita to double? ANSWER: 37 Years (approx.) So if it takes 37 years to double, how many years to be 8 times as large? ANSWER: Doubling 3 Times = 2 x 2 x 2 = 8 So it takes 3 x 37 years = 111 years If real GDP per capita grows at 1% per year, it will take 70 years to double. If it grows at 2% per year, it will take only 35 years to double. In fact, U.S. real GDP per capita rose on average 1.9% per year over the last century. Applying the Rule of 70 to this information implies that it should have taken 37 years for real GDP per capita to double; it would have taken 111 years—three periods of 37 years each—for U.S. real GDP per capita to double three times. That is, the Rule of 70 implies that over the course of 111 years U.S. real GDP per capita should have increased by a factor of 2 × 2 × 2 = 8. And this does turn out to be a pretty good approximation to reality, once we adjust for the fact that a century is a bit less than 111 years. During the twentieth century, U.S. real GDP per capita rose seven-fold, a bit less than eight-fold.

The Connection between Economic Prosperity and Health Making the Connection The Connection between Economic Prosperity and Health

Sources of Long-Run Growth Labor productivity, often referred to simply as productivity, is output per worker (usually one worker by one hour of work). Physical capital consists of human-made resources such as buildings and machines. Human capital is the improvement in labor created by the education and knowledge embodied in the workforce. Technology: A change in the quantity of output a firm can produce using a given quantity of inputs.

What Determines How Fast Economies Grow? There are three main sources of technological change: • Better machinery and equipment. • Increases in human capital. Human capital The accumulated knowledge and skills that workers acquire from education and training or from their life experiences. • Better means of organizing and managing production.

Accounting for Growth Aggregate Production Function: A hypothetical function that shows how real GDP per worker depends on the quantities of physical and human capital per worker as well as technology.

Diminishing Return to Physical Capital Aggregate Production Function exhibits diminishing returns to physical capital when: holding the amount of human capital and the state of technology fixed each successive increase in the amount of physical capital leads to a smaller increase in productivity.

Hypothetical Example

Physical Capital and Productivity Other things equal, a greater quantity of physical capital per worker leads to higher real GDP per worker, but is subject to diminishing returns: each successive addition to physical capital per worker produces a smaller increase in productivity.

The Per-Worker Production Function Which Is More Important for Economic Growth: More Capital or Technological Change? The Per-Worker Production Function The Per-Worker Production Function

Growth Accounting Growth accounting: estimates the contribution of each major factor in the aggregate production function to economic growth. Physical capital per worker grows 3% a year. According to estimates each 1% rise in physical capital per worker, holding human capital and technology constant, raises output per worker by 0.33%.

Technology and Productivity Technological progress shifts the productivity curve upward. Here we hold human capital per worker fixed. We assume that the lower curve (the same curve as in the previous graph) reflects technology in 1935, and the upper curve reflects technology in 2005. Total factor productivity is the amount of output that can be achieved with a given amount of factor inputs. Holding technology and human capital fixed, quadrupling physical capital per worker from $20,000 to $80,000 leads to a doubling of real GDP per worker, from $30,000 to $60,000. This is shown by the movement from point A to point C, reflecting an approximately 1% per year rise in real GDP per worker. In reality, technological progress shifted the productivity curve upward and the actual rise in real GDP per worker is shown by the movement from point A to point D. Real GDP per worker grew 2% per year, leading to a quadrupling during the period. The extra 1% in growth of real GDP per worker is due to higher total factor productivity.

What Determines How Fast Economies Grow? Technological Change: The Key to Sustaining Economic Growth Technological Change Increases Output per Hour Worked

What Explains the Economic Failure of the Soviet Union? Making the Connection What Explains the Economic Failure of the Soviet Union? A centrally planned economy, such as the Soviet Union’s, could not, over the long run, grow faster than a market economy. The Soviet Union collapsed in 1991, and contemporary Russia now has a more market-oriented system, although the government continues to play a much larger role in the economy than does the government in the United States. The fall of the Berlin Wall in 1989 symbolized the failure of Communism.

Natural Resources In the modern world, natural resources are a much less important determinant of productivity than human or physical capital for the great majority of countries. Some nations with very high real GDP per capita, such as Japan, have very few natural resources. Some resource-rich nations, such as Nigeria (which has sizable oil deposits), are very poor.

What Determines How Fast Economies Grow? New Growth Theory If technological change is the key to growth then what encourages the technological change? Government policy can help increase the accumulation of knowledge capital in three ways: • Protecting intellectual property with patents and copyrights. Patent: The exclusive right to a product for a period of 20 years from the date the product is invented. • Subsidizing research and development. • Subsidizing education.

Why Growth Rates Differ Countries differ greatly in their growth rates of real GDP per capita, largely due to differences in government policies and institutions that alter: savings and investment spending foreign direct investment Foreign portfolio investment (new) education Infrastructure (Roads, power lines, ports, IT networks research and development (create/implement tech) political stability the protection of property rights Roads, power lines, ports, information networks, and other underpinnings for economic activity are known as infrastructure. R&D is spending to create and implement new technologies. FOREIGN DIRECT INVESTMENT FOREIGN PORTFOLIO INVESTMENT- ADD!!

Political Stability & Property Rights Property rights: The rights individuals or firms have to the exclusive use of their property, including the right to buy or sell it. Rule of law: The ability of a government to enforce the laws of the country, particularly with respect to protecting private property and enforcing contracts.

Political Stability & Property Rights Political stability and protection of property rights are crucial ingredients in long-run economic growth. There’s not much point in investing in a business if rioting mobs are likely to destroy it or saving your money if someone with political connections can steal it.

Excessive Government Intervention Even when governments aren’t corrupt, excessive government intervention can be a brake on economic growth. If large parts of the economy are supported by government subsidies, protected from imports, or otherwise insulated from competition, productivity tends to suffer because of a lack of incentives.

Poor Countries Regulate Businesses The Most…. Note: The indicators for high-income countries are used as benchmarks. The average value of the indicator is shown above each column. Source: Doing Business database of the World Bank, 2004.

Success, Disappointment, and Failure South Korea and some other East Asian countries have been highly successful at achieving economic growth. Argentina, like much of Latin America, had relatively high real GDP per capita in the early twentieth century but has achieved little growth in real GDP per capita over the past half-century. Ghana, like most of Africa, started poor but has become even poorer over time. Source: World Bank.

Success in Economic Growth East Asian economies have done many things right and achieved very high growth rates. Savings and Investment Spending Emphasis on Education Adopting advanced technology Government Stability

Disappointment in Economic Growth In Latin America, where some important conditions are lacking, growth has generally been disappointing. Poor education Political Instability Irresponsible Government Corruption BRAIN DRAIN

Disappointment in Economic Growth In Africa, real GDP per capita has declined for several decades, although there are some signs of progress now. Severe Political and Economic Instability Poverty Itself Disease &War Geography Poor Infrastructure Public Health

Convergence Hypothesis Convergence Hypothesis: International differences in real GDP per capita tend to narrow (converge) over time. The growth rates of economically advanced countries have converged, but not the growth rates of countries across the world Factors that affect growth, such as education, infrastructure, and favorable policies and institutions must be held equal across countries. CATCHING UP!

Convergence? Data on today’s wealthy economies seem to support the convergence hypothesis. In panel (a) we see that among wealthy countries, those that had low levels of real GDP per capita in 1955 have had high growth rates since then, and vice versa. But for the world as a whole, there has been little sign of convergence. Panel (b) shows real GDP per capita in 1955 and subsequent growth rates in major world regions. Poorer regions did not consistently have higher growth rates than richer regions: poor Africa turned in the worst performance, and relatively wealthy Europe grew faster than Latin America.