1 Economics 285 Economic Growth I.B.M. Will Invest $5 Billion To Produce Newer Microchips – NY Times 10/10/2000

2 Economic Growth  Long-Term Growth Trends  The Sources of Economic Growth  Growth Accounting  Growth Theory  Achieving Faster Growth

3  Long-term growth trends are the trends in potential GDP Long-Term Growth Trends

4 A Hundred Years of Economic Growth in the United States

5 Economic Growth in Canada Figure shows long-term growth in Canada since Growth was fastest during the 1960s.

6  Fig. 11.2(a) shows growth in the biggest economies since  Japan has caught up with the other big economies. Long-Term Growth Trends

7 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.

8  Fig. 11.2(b) shows gaps in real GDP per person have been very persistent for most groups of countries. Long-Term Growth Trends

9  Fig shows some Asian economies closing the gap in real GDP per person. Long-Term Growth Trends

10  Economic growth occurs when incentives are created by: £ markets £ property rights £ monetary exchange The Sources of Economic Growth

11  The activities that generate growth are: £ saving and investment £ growth of human capital £ discovery of new technologies The Sources of Economic Growth

12  Growth accounting is the attempt to measure the contributions to growth of labor, capital, and technological change.  Real GDP growth equals the growth of real GDP per hour of work plus the growth rate of aggregate hours. Growth Accounting

13  The growth rate of real GDP per hour of work depends on: £ Growth of capital per hour of labor £ Technological change  Fig 11.4 is a time series plot of GDP per hour of work for US Growth Accounting

14 Real GDP per Hour of Work Fig time series plot of GDP per hour of work for US

15  Separates the effects of: £ Growth of capital per hour of labor £ Technological change  Hold technology constant, vary capital per hour of work Productivity function

16 Growth Accounting The Productivity Function £ Diminishing returns to capital,i.e., holding constant the quantity of labor, as we incrementally increase capital, the extra output that results gets smaller £ The one third rule explains how much less.

17 How Productivity Grows PF 0 Effect of technological change Effect of increase in capital stock Real GDP per hour of work (1992 dollars) Capital per hour of work (1992 dollars) 0 Fig. 11.5

18  One-third rule. Goal: Divide the increase in real GDP per hour of work into £ capital effect £ technological change effect Growth Accounting

19 Growth Accounting The One Third Rule £ Discovered by Robert Solow of MIT

20  An x percent increase in capital per hour of work brings a 1/3 of x percent increase in output per hour of work. Growth Accounting

21  The remaining increase in output per hour of work is attributed to technological change (and unidentified factors). Growth Accounting

22  Growth accounting is used to account for the productivity growth slowdown.  Figure 11.6 shows how this type of breakdown is made. Growth Accounting

23 Growth Accounting and the Productivity Growth Slowdown

24 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 32 percent. With no change in technology, the economy would have expanded by only 11 percent (1/3 of 32 percent).

25 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 16 percent. With no change in technology, the economy would have expanded by 5 percent (1/3 of 16 percent).

26 Growth Accounting Accounting for the Productivity Growth Slowdown and Speedup 1983 to 1998 The economy grew due to more rapid technological change. Real GDP per hour expanded by 22 percent. Capital per hour increased by 14 percent. With no change in technology, the economy would have expanded by only 5 percent (1/3 of 14 percent).

27 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

28 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

29 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.

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

31  The task of growth theory is to explain the trends in economic growth.  Three main theories have been proposed: £ Classical growth theory £ Neoclassical growth theory £ New growth theory Growth Theory

32 Growth Theory  In the first two technological change is due to chance £ Exogenous – determined outside the model  New growth theory – attempts to predict technological progress inside the model £ Endogenous -- determined by the model

33 Classical Growth Theory Real GDP growth is temporary £ Real GDP per person above subsistence £ Brings population explosion £ Returns real GDP per person back to the subsistence level. £ Malthusian theory.

34 Classical Growth Theory The Basic Idea (1776) £ Real GDP has increased £ Real wage rate has increased £ Population growth increases labor supply £ Wage falls due to diminishing returns to labor

35 Classical Growth Theory Subsistence real wage rate £ Minimum needed to maintain life. £ If the real wage rate falls below subsistence, some people cannot survive and population growth subsides

36 LD 1 Growth Begins LS 0 LD 0 Labor (millions) Real wage rate (1776 shillings per day) New technologies and more capital increase the productivity of labor

37 Subsistence real wage rate A Dismal Outcome LS 0 LS 1 LD 1 Labor (millions) Real wage rate (1776 shillings per day) When the real wage rate exceeds the subsistence level, the population increases

38 Modern Theory of Population Growth  Income levels and population growth may be inversely related £ Opposite of Malthus £ Income  death rate falls £ Income  birth rate falls  Relationship is weak

39 Notes on Modern Theory of Population Growth  The modern theory of population growth explains that the population growth is influenced by economic factors. £ 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 b/c the two effects are offsetting. £ 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.

40 Neoclassical Growth Theory  Technological change £ Induces saving and investment £ Makes capital per person grow

41 Neoclassical Growth Theory  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 (exogenous)

42 Neoclassical Growth Theory The Basic Idea £ Technological advances promise new profit opportunities £ ID increases, real interest rate rises £ Saving increases £ K stock grows £ Real GDP and YD grow

43 Neoclassical Growth Theory The Basic Idea (cont.) £ Prosperity will persist £ Growth will stop if technology stops advancing: profit leads to K accumulation diminishing returns to capital

44 Neoclassical Growth Theory Target Rate and Long-Run Saving £ When real interest rate exceeds the target rate, the K stock increases £ When the target rate exceeds real interest rate, the K stock decreases £ When real interest rate = the target rate, the K stock is constant

45 Neoclassical Growth Theory Target Rate and Long-Run Saving (cont.) £ Technology advances, real GDP grows but the growth rate diminishes £ New advances increase the demand for capital, raising the real interest rate and inducing saving £ Rate of technological progress is unpredictable

46 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.

47 Neoclassical Growth Theory A contradicted hypothesis? £ Technology and capital are mobile £ Therefore growth rates and per-capita income levels converge £ Data reveal that convergence is slow or absent Why?

48 ID 1 Neoclassical Growth Begins Savings and investment (trillions of 1992 dollars) Real interest rate (percent per year) SS 0 ID 0 10 Technological advances increase investment demand... …real interest rate, saving, and investment increase

49 KD 1 KS 1 Neoclassical Growth Ends KS 0 KD 0 10 Capital stock (trillions of 1992 dollars) Real interest rate (percent per year) LKS a b When the real interest rate exceeds the target rate, saving and investment increase the supply of capital.

50 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.

51 New 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.

52 New 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.

53 New Growth Theory Discoveries and Profits £ Profit spurs technological change. £ Competition forces firms to lower their costs of production and to improve their products. £ Eventually, discoveries are copied and profits disappear.

54 New 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.

55 New 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.

56 New 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.

57 New Growth Theory KS 0 10 Capital (trillions of 1992 dollars) Real interest rate (percent per year) LKS KD 0 KD 1 KS 1 KS 2 KS 3 a

58 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.

59 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. Diminishing returns to capital imply that we cannot keep growing just by accumulating capital.

60 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.

61 Next: International Finance