PowerPoint Slides prepared by: Andreea CHIRITESCU Eastern Illinois University 1 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 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., 1995 NOBEL PRIZE WINNER IN ECONOMICS

Productivity Growth Growth policy –Economy sustains a high long-run growth rate of potential GDP Not necessarily the highest possible growth rate Stabilization policy –Keeping actual GDP reasonably close to potential GDP in the short run So that society is plagued by neither high unemployment nor high inflation 2 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Productivity Growth Three pillars of productivity growth –Rate at which the economy builds up its stock of capital –Rate at which technology improves –The rate at which workforce quality (or “human capital”) is improving 3 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Productivity Growth Larger capital stock –For a given technology and a given labor force –Higher labor productivity Better technology –For a given capital and a given labor force –Higher labor productivity 4 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Productivity Growth Workforce quality –More education and training –For a given capital, a given technology, and a given labor force –Higher labor productivity Human capital (education & training) –Amount of skill embodied in the workforce –Measured by the amount of education and training 5 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Figure 1 Production Functions Corresponding to Three Different Capital Stocks 6 0 Hours of Labor Input Output L1L1 YaYa K1K1 YbYb YcYc K2K2 K3K3 c b a © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Levels, Growth, & Convergence Levels, growth rates, and the convergence hypothesis Level of productivity in a nation –Higher in rich countries –Depends on Its supplies of human and physical capital State of its technology 7 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Table 1 Productivity Levels and Productivity Growth Rates in Selected Countries 8 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Levels, Growth, & Convergence Growth rate of productivity –Depends on rates of increase of Physical capital Human capital Technology 9 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Levels, Growth, & Convergence Convergence hypothesis –Nations with low levels of productivity Tend to have high productivity growth rates –International productivity differences shrink over time –Poorer countries Higher productivity growth rates than richer countries 10 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Figure 2 The Convergence Hypothesis 11 0 Time Real GDP per capita $2,000 Poorer country $10,000 Richer country © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Levels, Growth, & Convergence Technological laggards –Can, and sometimes do, close the gap with technological leaders –By imitating and adapting existing technologies –“Convergence club” Productivity growth rates are higher –Where productivity levels are lower Some of the world’s poorest nations –Unable to join the club 12 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Table 2 Levels and Growth Rates of GDP per Capita in Selected Poor Countries 13 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Growth Policy Growth policy –Encouraging capital formation Nation’s capital –Its available supply of plant, equipment, and software –The result of past decisions to make investments in these items 14 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Growth Policy Investment –The flow of resources into the production of new capital –Labor, steel, and other inputs Devoted to the construction of factories, warehouses, railroads, and other pieces of capital During some period of time 15 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Growth Policy Capital formation –Investment –Process of building up the capital stock Trade-off –More capital formation Quicker growth and consume less today –More consumption today Less capital formation and slower growth 16 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Figure 3 Choosing between Investment and Consumption 17 0 Consumer Goods Produced Investment Goods Produced D C I A © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Growth Policy To speed up capital formation –Government must somehow persuade private businesses to invest more –Lower real interest rates –Tax provisions –Technical change –Growth of demand –Political stability and property rights 18 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Growth Policy Property rights –Laws and/or conventions –That assign owners the rights to use their property as they see fit (within the law) Sell the property Reap the benefits (such as rents or dividends) 19 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Table 3 Selected Countries Ranked by Level of Investor Protection 20 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Growth Policy Growth policy –Improving education and training More-educated and better-trained workers –Higher productivity –Higher wages Education policy –Improve quality of education 21 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Growth Policy Earning gap –Between high school graduates and college graduates –Job market – rewards the skills acquired in college On-the-job-training –Skills acquired at work 22 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Figure 4 Wage Premium for College Graduates over High School Graduates 23 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Growth Policy Growth policy –Spurring technological change Advancement of technology –More higher education Scientific, engineering, and managerial education –More capital formation –Research & development (R&D) 24 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Growth Policy Invention –Act of discovering new products or new ways of making products Innovation –Act of putting new ideas into effect Research and development (R&D) –Activities aimed at inventing new products or processes –Or improving existing ones 25 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Growth Policy Government –Subsidizes private R&D spending through the tax code –Joins with private companies in collaborative research efforts –Spends taxpayer money directly on R&D –Department of Defense –National Aeronautics and Space Administration (NASA) –National Science Foundation (NSF) –National Institutes of Health (NIH) 26 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Productivity in the U.S. Productivity growth in the U.S. –2.8% per year, –Slowdown to 1.4% per year, –2.4% per year, since © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Figure 5 Average Productivity Growth Rates in the United States, 1948– © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Productivity in the U.S. The Productivity Slowdown, 1973–1995 –Lagging investment Not supported by facts –High energy prices (oil) Skeptics: mid 1980s when energy prices dropped, no change in productivity growth –Inadequate workforce skills Debatable –Not: technological slowdown 29 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Productivity in the U.S , productivity speed-up, 2.6% –IT revolution –Surging investment –Strong national economy –Not: Falling energy prices –Advances in information technology 30 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Developing Countries Many poor countries –Poorly endowed with capital –Difficult to accumulate capital –Population: unable to save for the future –Need development assistance –Need foreign direct investment 31 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Developing Countries Development assistance, foreign aid –Outright grants and low-interest loans –From rich countries and multinational institutions –Purpose: to spur economic development Foreign direct investment –Purchase or construction of real business assets in a foreign country Often by multinational corporations 32 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Developing Countries Multinational corporations –Generally large corporations that do business in many countries –Most, but not all, have their headquarters in developed countries Low level of technology –Poor countries - unable to join the “convergence club” 33 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Developing Countries Poor levels of education and training –Low level of educational attainment Geographical conditions –Landlocked –Hot climate –Short on arable land 34 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Developing Countries Poor health –AIDS pandemic –Cholera epidemic –Poverty make is harder to improve health standards Poor and corrupt governance –Corruption, overregulation of business –Capricious government –Lawlessness, tyrannical rule, war 35 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Table 4 Average Educational Attainment in Selected Countries, 2000* 36 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

From the LR to the SR 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 37 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.