CHAPTER 11 Economic Growth ECONOMICS 5e Michael Parkin CHAPTER 11 Economic Growth Chapter 28 in Economics

Learning Objectives Describe the long-term growth trends in the United States and other countries and regions Identify the main sources of long-term real GDP growth Explain the productivity growth slowdown in the United States during the 1970s

Learning Objectives (cont.) Explain the rapid economic growth rates being achieved in East Asia Explain the theories of economic growth

Learning Objectives Describe the long-term growth trends in the United States and other countries and regions Identify the main sources of long-term real GDP growth Explain the productivity growth slowdown in the United States during the 1970s

Long-Term Growth Trends We are interested in long-term growth primarily because it brings rising incomes per person.

A Hundred Years of Economic Growth in the United States Instructor Notes: 1) During the 100 years from 1896 to 1996, real GDP per person in the United States grew by 2 percent a year, on the average. 2) The growth rate was above average during the 1920s and 1960s, and it was below average in 1903-1920, the 1950s, and 1973-1996.

Long-Term Growth Trends Real GDP Growth in the World Economy The United States has the highest real GDP per person, and Canada has the second highest Europe’s Big 4 (France, Germany, Italy, and the United Kingdom) were the third richest countries until 1985 when Japan caught up to them.

Learning Objectives (cont.) Explain the rapid economic growth rates being achieved in East Asia Explain the theories of economic growth Describe the policies that might be used to speed up economic growth

Economic Growth Around the World: Catch-Up or Not? Instructor Notes: 1) Real GDP per person has grown throughout the world economy. 2) Among the rich industrial countries, real GDP growth has been faster in Canada, the big four Western European countries (France, Germany, Italy, and the United Kingdom), and Japan than in the United States and they are catching up. 3) The most spectacular growth was in Japan during the 1960s. 4) The income level in Canada has also become closest to the U.S. income level.

Economic Growth Around the World: Catch-Up or Not? Instructor Notes: 1) Real GDP per person has grown throughout the world economy. 2) Among the rich industrial countries, real GDP growth has been faster in Canada, the big four Western European countries (France, Germany, Italy, and the United Kingdom), and Japan than in the United States and they are catching up. 3) The most spectacular growth was in Japan during the 1960s. 4) The income level in Canada has also become closest to the U.S. income level.

Catch-Up Asia Instructor Notes: 1) The clearest examples of catch-up have occurred in five economies in Asia. 2) Starting out in 1960 with incomes as little as one tenth of that in the United States, four Asian economies (Hong Kong, Korea, Singapore, and Taiwan) have substantially narrowed the gap on the United States. 3) An from being a very poor developing country in 1960, China’s income now exceeds the income level that Hong Kong had in 1960. 4) China is growing at a rate that is enabling it to continue to catch up with the United States.

Learning Objectives Describe the long-term growth trends in the United States and other countries and regions Identify the main sources of long-term real GDP growth Explain the productivity growth slowdown in the United States during the 1970s

The Causes of Economic Growth: A First Look Preconditions for Economic Growth 1) Markets 2) Property rights 3) Monetary exchange

The Causes of Economic Growth: A First Look Activities that Generate Ongoing Economic Growth Saving and Investment in New Capital Investment in Human Capital Discovery of New Technologies

The Causes of Economic Growth: A First Look Saving and Investment in New Capital New capital increases the capital per worker and increases real GDP per hour of labor — labor productivity.

The Causes of Economic Growth: A First Look Investment in Human Capital The accumulated skill and knowledge of human beings is the most fundamental source of economic growth.

The Causes of Economic Growth: A First Look Discovery of New Technologies The discovery and the application of new technologies and new goods has increased labor productivity tremendously.

Learning Objectives Describe the long-term growth trends in the United States and other countries and regions Identify the main sources of long-term real GDP growth Explain the productivity growth slowdown in the United States during the 1970s

Growth Accounting The quantity of real GDP supplied (Y) depends on three factors: 1) The quantity of labor (N) 2) The quantity of capital (K) 3) The state of technology (T)

Growth Accounting Y = F(N,K,T) Growth accounting is used to calculate how much real GDP growth results from growth of labor and capital and how much is attributable to technological change. A key tool is the aggregate production function: Y = F(N,K,T)

Growth Accounting Labor Productivity Labor productivity is real GDP per hour of work. Equals real GDP divided by aggregate labor hours Determines how much income an hour of labor generates

Real GDP per Hour of Work Instructor Notes: 1) Real GDP divided by aggregate hours equals real GDP per hour of work, which is a broad measure of productivity. 2) During the 1960s, the productivity growth rate was high. 3) It slowed during the 1970s and speeded up again after 1983.

Growth Accounting Growth accounting divides growth into two components. 1) Growth in capital per hour of labor 2) Technological change Includes everything that contributes to labor productivity growth that is not included in growth in capital per hour

Growth Accounting The Productivity Function A relationship that shows how real GDP per hour of labor changes as the amount of capital per hour of labor changes with a given state of technology.

Growth Accounting The Productivity Function The shape of the productivity function reflects the law of diminishing returns. The law of diminishing returns states that as the quantity of one input increases with the quantities of all other inputs remaining the same, output increases but by ever smaller increments.

How Productivity Grows PF0 32 PF0 Effect of technological change 25 Real GDP per hour of work (1992 dollars) 20 Effect of increase in capital stock Instructor Notes: 1) Technological advance shifts the productivity function upward. 2) Here, an advance in technology shifts the productivity function from PF0 to PF1. 3) With this technological advance, real GDP per hour of work increases from $25 to $32 when there is $60 of capital per hour of work. 30 60 Capital per hour of work (1992 dollars)

Growth Accounting The Productivity Function Applying the law of diminishing returns to capital, the law states that if a given number of hours of labor use more capital, the additional output that results from the additional capital gets smaller as the amount of capital increases. The one third rule explains how much less.

Growth Accounting The One Third Rule Robert Solow of MIT discovered that on average, with no change in technology, a 1 percent increase in capital per hour of labor brings a one third of a 1 percent increase in real GDP per hour of labor.

Growth Accounting Accounting for the Productivity Growth Slowdown and Speedup We can use the one third rule to study U.S. productivity growth and the productivity growth slowdown.

Growth Accounting Accounting for the Productivity Growth Slowdown and Speedup 1960 to 1973 The economy grew due to rapid technological changes. Real GDP per hour expanded by 39 percent. Capital per hour increased by 24 percent. With no change in technology, the economy would have expanded by only 8 percent (1/3 of 24 percent).

Growth Accounting Accounting for the Productivity Growth Slowdown and Speedup 1973 to 1983 Predominantly, the reason for the productivity growth slowdown can be attributed to a decline in the rate of technological change. Real GDP per hour expanded by 8 percent. Capital per hour increased by 15 percent. With no change in technology, the economy would have expanded by 5 percent (1/3 of 15 percent).

Growth Accounting Accounting for the Productivity Growth Slowdown and Speedup 1983 to 1995 The economy grew due to more rapid technological change. Real GDP per hour expanded by 18.5 percent. Capital per hour increased by 11 percent. With no change in technology, the economy would have expanded by only 3.7 percent (1/3 of 11 percent).

Growth Accounting and the Productivity Growth Slowdown Instructor Notes: 1) Between 1960 and 1973, which was a period of rapid productivity growth, capital per hour of work increased from $49 to $61, and technological progress shifted the productivity function upward from PF0 to PF1. 2) Between 1973 and 1983, when potential GDP grew slowly, capital per hour of work increased from $61 to $70 and the productivity function shifted to PF2. 3) The effect of technological change was offset by oil price shocks. 4) Between 1983 and 1995, capital per hour of work increased from $70 to $78 and technological progress shifted the productivity function upward from PF2 to PF3. 5) Although productivity growth was not as rapid as in the 1960s, the productivity growth rate did increase.

Growth Accounting Technological Change During the Productivity Growth Slowdown Technology was directed toward coping with two major problems. 1) Energy price shocks 2) The environment

Growth Accounting Technological Change During the Productivity Growth Slowdown Energy Price Shocks 1973–1974 and 1979—1980 Fuel inefficient methods of transportation and production were scrapped at an increased rate Technological change focused on saving energy rather than enhancing productivity

Growth Accounting Technological Change During the Productivity Growth Slowdown The Environment The 1970s saw an expansion of laws and resources devoted to protecting the environment and improving the quality of the workplace. These benefits are not included in real GDP.

Growth Accounting Achieving Faster Growth Stimulate Saving Stimulate high-technology industries Target high-technology industries Encourage international trade Improve the quality of education

Learning Objectives (cont.) Explain the rapid economic growth rates being achieved in East Asia Explain the theories of economic growth

Growth Theory Three theories that attempt to explain what causes economic growth and makes growth rates vary are: 1) Classical Growth Theory 2) Neoclassical Growth Theory 3) New Growth Theory

Growth Theory Classical Growth Theory The view that real GDP growth is temporary and that when real GDP per person rises above the subsistence level a population explosion eventually brings real GDP per person back to the subsistence level. Thomas Malthus is given most of the credit for the theory, hence the name Malthusian theory.

Growth Theory Classical Growth Theory The Basic Idea The world of 1776: Real GDP has increased and the real wage rate has increased. But the classical economists believe that this new situation can’t last because it will induce a population explosion.

Growth Theory Classical Growth Theory The modern theory of population growth explains that the population growth is influenced by economic factors.

Growth Theory Modern Theory of Population Growth If there is any relationship between income levels and population growth, it is the opposite of that feared by the classical economists. In reality, the relationship is weak. The relation is so weak that it can be said that the rate of population growth is virtually independent of the rate of economic growth.

Growth Theory Classical Growth Theory Subsistence real wage rate - to explain the high rate of population growth The subsistence real wage rate is the minimum real wage rate needed to maintain life. If the actual real wage rate is less than the subsistence real wage rate, some people cannot survive and the population decreases.

Growth Begins LD1 LS0 5 4 3 2 1 LD0 1 2 3 4 5 6 New technologies and more capital increase the productivity of labor 4 Real wage rate (1776 shillings per day) 3 2 Instructor Notes: 1) An advance in technology and an increase in capital increase the productivity of labor, and the demand for labor increases to LD1. 2) The real wage rate rises to 4 shillings a day, and the quantity of labor supplied increases to 3 million. 1 LD0 1 2 3 4 5 6 Labor (millions)

A Dismal Outcome LS0 5 LS1 4 3 2 1 LD1 1 2 3 4 5 6 When the real wage rate exceeds the subsistence level, the population increases 4 3 Real wage rate (1776 shillings per day) Subsistence real wage rate 2 Instructor Notes: 1) With an increase in population the supply of labor increases, and the labor supply curve shifts rightward to LS1. 2) As it does so, the real wage rate falls and the quantity of labor employed increases. 3) The population stops growing when the real wage rate is back at the subsistence level. 1 LD1 1 2 3 4 5 6 Labor (millions)

Growth Theory Neoclassical Growth Theory Holds that real GDP per person grows because technological change induces saving and investment that makes capital per person grow. The Neoclassical Economics of Population Growth: The population explosion of eighteenth century Europe that created the classical theory of population eventually ended. Made classical theory less relevant.

Growth Theory Neoclassical Growth Theory Technological change The rate of technological change influences the rate of economic growth, but economic growth does not influence the pace of technological change. Technological change results from chance.

Growth Theory Neoclassical Growth Theory The Basic Idea These technological advances bring new profit opportunities. Businesses expand and new businesses are created to exploit the newly profitable technologies.

Growth Theory Neoclassical Growth Theory The Basic Idea (cont.) Investment and savings increase. The economy enjoys new levels of prosperity and growth.

Growth Theory Neoclassical Growth Theory The Basic Idea (cont.) According to the neoclassical growth theory, the prosperity will persist because there is no classical population growth induced to lower wages.

Growth Theory Neoclassical Growth Theory The Basic Idea (cont.) Growth will stop if technology stops advancing for two reasons: high profit rates diminishing returns to capital

Growth Theory Neoclassical Growth Theory Target Rate and Long-Run Saving If real the real interest rate exceeds the target rate, the supply of capital increases. If the real interest rate is less than the target rate, the supply of capital decreases. If the real interest rate is equal to the target rate, the supply of capital is constant.

Growth Theory Neoclassical Growth Theory Target Rate and Long-Run Saving (cont.) Throughout the process, real GDP grows but the growth rate gradually decreases and eventually ends. Ongoing capital advances are constantly increasing the demand for capital, raising the real interest rate and inducing saving.

Growth Theory Neoclassical Growth Theory Target Rate and Long-Run Saving (cont.) The process repeats as long as technology advances, creating an on-going process of long-term economic growth.

Growth Theory Neoclassical Growth Theory Problems with Neoclassical Growth Theory All economies have access to the same technologies, and capital is free to roam the globe seeking the highest available rate of return. This implies that growth rates and income levels per person around the globe converge.

Growth Theory Neoclassical Growth Theory Problems with Neoclassical Growth Theory In reality, this convergence is slow and does not appear imminent for all countries.

Neoclassical Growth Begins Technological advances increase investment demand... 10 SS0 ID1 8 Real interest rate (percent per year) …real interest rate, saving, and investment increase 6 4 Instructor Notes: 1) Investment demand increases to ID1. 2) The real interest rate rises to 6 percent a year, and investment increases to $1.5 trillion. 3) As a result, the quantity of capital and real GDP begin to grow. 2 ID0 0.5 1.0 1.5 2.0 2.5 Savings and investment (trillions of 1992 dollars)

Neoclassical Growth Ends KS0 KS1 10 When the real interest rate exceeds the target rate, saving and investment increase the supply of capital. KD1 8 Real interest rate (percent per year) 6 a b 4 LKS Instructor Notes: 1) A technological advance increases the productivity of capital and increases the demand for capital to KD1. 2) The real interest rate rises. 3) But so do investment and saving. 4) As the capital stock increases, the KS curve shifts rightward toward KS1. 5) The real interest rate falls. 6) When the real interest rate has fallen to its long-run target rate, the supply of capital stops increasing, the capital stock is constant at $20 trillion, and growth ends. 2 KD0 5 10 15 20 25 Capital stock (trillions of 1992 dollars)

Growth Theory New Growth Theory Holds that real GDP per person grows because of the choices that people make in the pursuit of profit and that growth can persist indefinitely.

Growth Theory New growth theory begins with two facts about market economies: 1) Discoveries result from choices. 2) Discoveries bring profit, and competition destroys profit.

Growth Theory Discoveries and Choices The pace of discoveries is not determined by chance. It depends on how many people are looking for a new technology and how intensively they are looking.

Growth Theory Discoveries and Profits Profit spurs technological change. Competition forces firms to seek lower-cost methods of production or new and better products. Eventually, discoveries are copied and profits disappear.

Growth Theory Two other facts are key to new growth theory: 1) Discoveries can be used by many people at the same time. 2) Physical activities can be replicated.

Growth Theory Discoveries Used by All: Once a profitable new discovery has been made, everyone can use it. As the benefits spread, free resources become available because nothing is given up when they are used.

Growth Theory Replicating Activities: The economy does not experience diminishing returns when it adds new factories identical to existing ones. Therefore, real GDP per person increases and does so indefinitely as long as people can undertake research and development that yields a higher return than the target real interest rate.

New Growth Theory KS0 KS1 KS2 KS3 10 8 6 KD1 4 LKS KD0 2 1 2 3 4 5 Real interest rate (percent per year) 6 KD1 4 LKS Instructor Notes: 1) The capital supply curve shifts rightward successively through KS1, KS2 , KS3 , and so on. 2) As capital grows, real GDP grows but the real interest rate does not fall because there are no diminishing returns. 3) Real GDP growth continues indefinitely. a KD0 2 1 2 3 4 5 Capital (trillions of 1992 dollars)

Growth Theory Sorting Out the Theories Probably none is exactly correct Classical theory reminds us that our physical resources are limited and that with no advances in technology we must eventually hit diminishing returns.

Growth Theory Sorting Out the Theories Probably none is exactly correct Neoclassical theory reaches essentially the same conclusion, but not because of a population explosion. It emphasized diminishing returns to capital and we cannot keep growth just by accumulating capital.

Growth Theory Sorting Out the Theories Probably none is exactly correct New growth theory emphasized the possible capacity of human resources to innovate at a pace that offsets diminishing returns.

The End