Principles of Macroeconomics Lecture 9 ECONOMIC GROWTH & DEVELOPMENT

The World Economy Total GDP (2008): $70T Population (2009 est): 6.8B GDP per Capita: $10,000 Population Growth: 1.17% GDP Growth (2008 est.): 3.8% GDP per capita is probably the best measure of a country’s well being

The World Economy Region GDP % of World GDP GDP Per Capita Real GDP Growth United States $14T 20% $47,000 1.3% European Union $15T 21% $33,000 1.0% Japan $4.3T 6% $34,200 -.4% China $7.8T 11% $6,000 9.8% India $3.2T 5% $2,800 6.6% Ethiopia $66.3B .09% $800 8.5% Source: CIA World Factbook

The World Economy United States GPD/Capita: $47,000 GDP Growth: 1.3% Currently, GDP per capita in the US is around 8 times that in China. However, at the current growth rates, that will shrink to a factor of 1.5 over the next two decades! China GDP/Capita: $6,000 GDP Growth: 9.8% United States GPD/Capita: $47,000 GDP Growth: 1.3%

The World Economy Per Capita Income

Economic growth Income GDP/Capita GDP Growth Low $510 6.3% Middle As a general rule, low income (developing) countries tend to have higher average rates of growth than do high income countries Income GDP/Capita GDP Growth Low $510 6.3% Middle $2,190 7.0% High $32,040 3.2% The implication here is that eventually, poorer countries should eventually “catch up” to wealthier countries in terms of per capita income – a concept known as “convergence”

Economic growth Some countries, however, don’t fit the normal pattern of development Zimbabwe GDP: $2B GDP Per Capita: $200 GDP Growth: -12.6% Macau (China) GDP: $18B GDP Per Capita: $30,000 GDP Growth: 15% So, what is Zimbabwe doing wrong? (Or, what is Macau doing right?) At current rates, Per capita income is Macau will quadruple to $120,000 over the next decade. This will make Macau the wealthiest country in the world. Over the same time period, per capita GDP in Zimbabwe will drop by roughly 75%to $52!!!

To understand this, let’s look at the sources of economic growth… To understand this, let’s look at the sources of economic growth….where does production come from? “is a function of” Real GDP Productivity Capital Stock Labor Real GDP = Constant Dollar (Inflation adjusted) value of all goods and services produced in the United States Capital Stock = Constant dollar value of private, non-residential fixed assets Labor = Private Sector Employment Productivity = Production unaccounted for by capital or labor

The World Economy Growth accounting breaks down GDP growth into growth of the three factors. Starting with a production function, take the complete derivative… Change in production Change in production per unit change in A Change in A

The World Economy Contributions to growth from capital, labor, and technology vary across time period 1939 - 1948 1948 - 1973 1973-1993 1993-2007 Output 5.79 4.10 1.96 2.63 Capital 3.34 4.24 2.10 2.94 Labor 4.46 1.86 1.60 Productivity 1.71 1.28 0.02 0.59 Some facts to notice: - Real GDP growth is declining over time. - Capital has been growing faster than labor

A better measure of economic well being is per capita GDP, so let us convert variables to per capita terms Divide both sides by labor to represent our variables in per capita terms Capital/Labor Ratio Productivity (Technology) Per capita output In general, let us assume lower case letters refer to per capita variables

Capital exhibits diminishing marginal productivity – that is as capital relative to labour rises, its contribution to production shrinks

Economic Growth

Economic Growth

Economic Development Most countries follow the “usual” pattern of development 1 Developing countries have very little capital, but A LOT of labour. Hence, the price of labor is low, the return to capital is very high 2 High returns to capital attract a lot of investment. As the capital stock grows relative to the labour force, output, consumption, and real wages grow while interest rates (returns to capital fall) 3 Eventually, a country “matures” (i.e. reaches its steady state level of capital). At this point, growth can no longer be achieved by investment in capital. Growth must be “knowledge based” – improving productivity! That means technological improvement! Productivity

Economic Development Developing countries are well below their steady state and, hence should grow faster than developed countries who are at or near their steady states – a concept known as absolute convergence Examples of Absolute Convergence (Developing Countries) China (GDP per capita = $6,300, GDP Growth = 9.3%) Armenia (GDP per capita = $5,300, GDP Growth = 13.9%) Chad (GDP per capita = $1,800, GDP Growth = 18.0%) Angola (GDP per capita = $3,200, GDP Growth = 19.1%) Examples of Absolute Convergence (Mature Countries) Canada (GDP per capita = $32,900, GDP Growth = 2.9%) United Kingdom (GDP per capita = $30,900, GDP Growth = 1.7%) Japan (GDP per capita = $30,700, GDP Growth = 2.4%) Australia (GDP per capita = $32,000, GDP Growth = 2.6%)

Economic Development Some countries, however, don’t fit the traditional pattern. Developing Countries with Low Growth Zimbabwe (GDP per capita = $2,100, GDP Growth = - 7.0%) Iraq (GDP per capita = $3,400, GDP Growth = - 3.0%) North Korea (GDP per capita = $1,800, GDP Growth = 1.0%) Haiti (GDP per capita = $1,600, GDP Growth = 1.5%) Developed Countries with high Growth Hong Kong (GDP per capita = $37,400, GDP Growth = 6.9%) Iceland (GDP per capita = $34,900, GDP Growth = 6.5%) Singapore (GDP per capita = $29,900, GDP Growth = 5.7%)

Economic Development Haiti Argentina Conditional convergence suggests that every country converges to its own unique steady state. Countries that are close to their unique steady state will grow slowly while those far away will grow rapidly. Steady State (Haiti) High Population Growth (Haiti) Low Population Growth (Argentina) Haiti Population Growth: 2.3% GDP/Capita: $1,600 GDP Growth: -1.5% Argentina Population Growth: .96% GDP/Capita: $13,700 GDP Growth: 8.7% (Argentina) Haiti is currently ABOVE its steady state (GDP per capita is falling due to a high population growth rate Argentina, with its low population growth is well below its steady state growing rapidly towards it

Economic Development Zimbabwe Hong Kong GDP/Capita: $2,100 GDP Growth: -7% Investment Rate (%0f GDP): 7% High Savings Rate (Hong Kong) Hong Kong GDP/Capita: $37,400 GDP Growth: 6.9% Investment Rate (% of GDP): 21.2% Low Savings Rate (Zimbabwe) Steady State (Zimbabwe) Steady State (Hong Kong) Hong Kong, with its high investment rate is well below its steady state growing rapidly towards it Zimbabwe is currently ABOVE its steady state (GDP per capita is falling due to low investment rate

Economic Development France USA GDP/Capita: $30,000 GDP Growth: 1.6% Government (%0f GDP): 55% Small Government (US) Large Government (France) USA GDP/Capita: $42,000 GDP Growth: 3.5% Government (% of GDP): 18% Steady State (France) Steady State (USA) The smaller government of the US increases the steady state and, hence, economic growth France has a lower steady state due to its larger public sector. Even though its per capita income is lower than the US, its growth is slower

Economic Development Suggestions for growth High income countries with low growth are at or near their steady state. Policies that increase capital investment will not be useful due to the diminishing marginal product of capital. - Consider investments in technology and human capital to increase your steady state. - Consider limiting the size of your government to shift resources to more productive uses (efficiency vs. equity) Low income countries with low growth either have a low steady state or are having trouble reaching their steady state - Consider policies to lower your population growth. - Try to increase your pool of savings (open up to international capital markets) - Policies aimed at capital formation (property rights, tax credits, etc).

Helpful Reading Economics. Samuelson, & Nordhaus (2005) Ch. 27-28