Long-Run Growth

Robert Lucas "Is there some action a government of India could take that would lead the Indian Economy to grow like Indonesia’s or Egypt’s? If so, what exactly? If not, what is it about the “nature of India” that makes it so? The consequences for human welfare involved in questions like these are simply staggering: Once one starts to think about them it is hard to think of anything else.

Why is Growth important? Measures of Welfare

Economic Growth from 1,000,000 B.C. to the Present World economic growth was essentially zero in the years before 1300, and it was very slow—an average of only 0.2 percent per year— before The Industrial Revolution made possible the sustained increases in real GDP per capita that have allowed some countries to attain high standards of living.

Long-Run Growth Economic growth refers to an increase in the total output of an economy. Defined by some economists as an increase of real GDP per capita.

Long-Run Growth Modern economic growth is the period of rapid and sustained increase in real output per capita that began in the Western World with the Industrial Revolution.

The Growth Process: From Agriculture to Industry The production possibility frontier (ppf) shows all the combinations of output that can be produced if all society’s scarce resources are fully and efficiently employed. Economic growth expands society’s production possibilities, shifting the ppf up and to the right.

The Growth Process: From Agriculture to Industry Before the Industrial Revolution in Great Britain, every society in the world was agrarian. Beginning in England around 1750, technical change and capital accumulation increased productivity in two important industries: agriculture and textiles. More could be produced with fewer resources, leading to new products, more output, and wider choice.

The Sources of Economic Growth An aggregate production function is the mathematical representation of the relationship between inputs and national output, or gross domestic product.

The Sources of Economic Growth If you think of GDP as a function of both labor and capital, you can see that an increase in GDP can come about through: 1.An increase in the labor supply 2.An increase in physical or human capital 3.An increase in productivity (the amount of product produced by each unit of capital or labor)

An Increase in Labor Supply An increasing labor supply can generate more output, but if the capital stock remains fixed, the new labor will be less productive (diminishing returns).

An Increase in Labor Supply Malthus and Ricardo predicted a gloomy future as population outstripped the land’s capacity to produce. However, they forgot the impact of technological change and capital accumulation.

An Increase in Labor Supply Growth in the labor force, without a corresponding increase in the capital stock or technological change, might lead to growth of output but declining productivity and a lower standard of living.

An Increase in Labor Supply Economic Growth from an Increase in Labor – More Output but Diminishing Returns and Lower Labor Productivity PERIOD QUANTITY OF LABOR L (HOURS) QUANTITY OF CAPITAL K (UNITS) TOTAL OUTPUT Y (UNITS) MEASURED LABOR PRODUCTIVITY Y/L

An Increase in Labor Supply Labor productivity is the output per worker hour; the amount of output produced by an average worker in 1 hour.

An Increase in Labor Supply Employment, Labor Force, and Population Growth, 1947 – 2002 CIVILIAN NONINSTITUTIONAL POPULATION OVER 16 YEARS OLD (MILLIONS) CIVILIAN LABOR FORCE EMPLOYMENT (MILLIONS) Number (Millions) Percentage of Population Percentage change, 1947 – Annual rate+ 1.4%+1.6%+ 1.6% Source: Economic Report of the President, 2003, Table B-35.

An Increase in Labor Supply As long as the economy and the capital stock are expanding rapidly enough, new entrants into the labor force do not displace other workers.

Increases in Physical Capital An increase in the stock of capital can increase output, even if it is not accompanied by an increase in the labor force.

Increases in Physical Capital Economic Growth from an Increase in Capital – More Output, Diminishing Returns to Added Capital, Higher Measured Labor Productivity PERIOD QUANTITY OF LABOR L (HOURS) QUANTITY OF CAPITAL K (UNITS) TOTAL OUTPUT Y (UNITS) MEASURED LABOR PRODUCTIVITY Y/L

Increases in Physical Capital The increase in capital stock is the difference between gross investment and depreciation. Capital has been increasing faster than the labor force since When capital expands more rapidly than labor, the ratio of capital to labor (K/L) increases, and this too is a source of increasing productivity.

Increases in Physical Capital Fixed Private Nonresidential Net Capital Stock, 1960 – 2001 (Billions of 1996 Dollars) EQUIPMENTSTRUCTURES , ,154.82, ,989.83, ,722.54, ,480.05,682.5 Percentage change, 1960 – Annual rate+ 4.7%+ 2.6% Source: Survey of Current Business, September 2002, Table 15, p. 37.

Increases in Human Capital Years of School Completed by People Over 25 Years Old, 1940 – 2000 PERCENTAGE WITH LESS THAN 5 YEARS OF SCHOOL PERCENTAGE WITH 4 YEARS OF HIGH SCHOOL OR MORE PERCENTAGE WITH 4 YEARS OF COLLEGE OR MORE NA NA NA = not available. Source: Statistical Abstract of the United States, 1990, Table 215; and 2002, Table 208.

Increases in Productivity Growth that cannot be explained by increases in the quantity of inputs can be explained only by an increase in the productivity of those inputs.

Increases in Productivity The productivity of an input is the amount produced per unit of an input. Factors that affect the productivity of an input include technological change, other advances in knowledge, and economies of scale.

Increases in Productivity Technological change affects productivity in two stages: – First there is an advance in knowledge, or an invention. – Then there is innovation, or the use of new knowledge to produce a new product or to produce an existing product more efficiently. There are capital-saving innovations, and labor- saving innovations.

Increases in Productivity External economies of scale are cost savings that result from increases in the size of industries. Production abatement requirements divert capital and labor from the production of measured output, therefore reducing measured productivity.

Growth and Productivity in the United States Growth of Real GDP in the United States, 1871 – 2000 PERIOD AVERAGE GROWTH RATE PER YEARPERIOD AVERAGE GROWTH RATE PER YEAR Sources: Historical Statistics of the United States: Colonial Times to 1970, Tables F47-70, F98-124; U.S. Department of Commerce, Bureau of Economic Analysis.

Growth and Productivity in the United States Growth of Real GDP in the United States and Other Countries, 1981 – 1998 COUNTRY AVERAGE GROWTH RATE PER YEAR United States3.2 Japan2.3 Germany2.2 France2.1 Italy2.0 United Kingdom2.6 Canada3.1 Africa2.7 Asia (excluding Japan)7.2 Source: Economic Report of the President, 2002, computed from Table B-112.

Sources of Growth in the U.S. Economy, 1929 – 1982 Sources of Growth in the United States, 1929 – 1982 PERCENT OF GROWTH ATTRIBUTABLE TO EACH SOURCE 1929 – – – – 1979 Increases in inputs Labor Capital Education (human capital) Increases in productivity Advances in knowledge Other factors a  2 Annual growth rate in real national income a Economies of scale, weather, pollution abatement, worker safety and health, crime, labor disputes, and so forth. Source: Edward Denison, Trends in American Economic Growth, 1929 – 1982 (Washington: Brookings Institution, 1985).

Labor Productivity: 1952 – 2003

Some of the explanations for the slowdown in productivity growth in the 1970s include: – A low rate of saving – Increased environmental and government regulations – Lack of spending in R&D – High energy costs

Labor Productivity: 1952 – 2003 Many of these factors turned around in the 1980s and 1990s, yet productivity growth remained low.

Economic Growth and Public Policy Policy provisions to improve the quality of education include the new Education Individual Retirement Account that allows savings to earn tax free returns as long as the balance is used to pay for educational expenses.

Economic Growth and Public Policy Policies to increase the saving rate include individual retirement accounts that accumulate earnings without paying income tax.

Economic Growth and Public Policy The amount of capital accumulation is ultimately constrained by its rate of saving. The tax system and the social security system in the United States are biased against saving.

Economic Growth and Public Policy Some public finance economists favor shifting to a system of consumption taxation rather than income taxation to reduce the tax burden on saving.

Economic Growth and Public Policy Other public policies to stimulate economic growth include: – Policies to stimulate investment – Policies to increase research and development – Reduced regulations – Industrial policy, or government involvement in the allocation of capital across manufacturing sectors.

The Pro-growth Argument Advocates of growth believe growth is progress. New technologies and production methods lead to new and better products. Capital accumulation and new technology improve the quality of life.

The Progrowth Argument Growth saves the most valuable commodity—time. Growth also improves the quality of things that yield satisfaction directly.

The Progrowth Argument Growth produces jobs and higher incomes. With higher incomes we can better afford the sacrifices needed to help the poor. When population growth is not accompanied by growth in output, unemployment and poverty increase.

The Antigrowth Argument Growth has negative effects on the quality of life. Growth encourages the creation of artificial needs. – Consumer sovereignty is the notion that people are free to choose, and that things that people do not want will not sell. “The consumer rules.”

The Anti-growth Argument Growth means the rapid depletion of a finite quantity of resources. Growth requires an unfair income distribution and propagates it.

Economic Growth in Developing and Transitional Economies

Nature’s Inequalities – Geography – Institutions matter(Daron Acemoglu) Solow’s Surprise – Capital matters, but only to a point. – Growth comes from Technology (productivity)

Economic Growth in Developing and Transitional Economies The universality of scarcity makes economic analysis relevant to all nations. Economic problems and policy instruments are different, but economic thinking about these problems can be transferred easily from country to country.

Life in the Developing Nations: Population and Poverty The United States and other industrialized economies rarely face the difficulties faced by developing nations: – chronic food shortages – explosive population growth – hyperinflations – low productivity and low GDP per capita – primitive shelter – illiteracy – infant mortality

Life in the Developing Nations: Population and Poverty Indicators of Economic Development COUNTRY GROUP POPULATION (MILLIONS) 2002 GROSS NATIONAL INCOME PER CAPITA, 2002 (DOLLARS) ANNUAL HEALTH EXPENDITURES PER CAPITA 2001 (DOLLARS) INFANT MORTALITY, 2001 (DEATHS BEFORE AGE FIVE PER 1,000 BIRTHS) PERCENTAGE OF POPULATION IN URBAN AREAS, 2001 Low-income (e.g., China, Ethiopia, Haiti, India) 2, Lower middle-income (e.g., Guatemala, Poland, Philippines, Thailand) 2,4111, Upper middle-income (e.g., Brazil, Malaysia, Mexico) 3315, Industrial market economies (e.g., Japan, Germany, New Zealand, United States) 96526,3102, Source: World Bank,

Life in the Developing Nations: Population and Poverty In the year 2002, the world population reached over 6.2 billion people. Most of the world’s more than 200 nations belong to the developing world. While the developed nations account for only about one-quarter of the world’s population, they consume about three-quarters of the world’s output. Developing countries have three-fourths of the world’s population, but only one-fourth of the world’s income.

Economic Development: Sources and Strategies Almost all developing nations have a scarcity of physical capital relative to other resources, especially labor. – The vicious-circle-of-poverty hypothesis suggests that poverty is self-perpetuating because poor nations are unable to save and invest enough to accumulate the capital stock that would help them grow. Poverty alone cannot explain capital shortages, and poverty is not necessarily self-perpetuating.

The Sources of Economic Development Capital flight is the tendency for both human capital and financial capital to leave developing countries in search of higher rates of return elsewhere. – Price ceilings, import controls, and expropriation are some of the policies that discourage investment. – The absence of productive capital prevents income from rising.

The Sources of Economic Development Just as financial capital seeks the highest return, so does human capital: – Brain drain is the tendency for talented people from developing countries to become educated in a developed country and remain there after graduation. Development cannot proceed without human resources capable of initiating and managing economic activity.

The Sources of Economic Development Social overhead capital is the basic infrastructure projects such as roads, power generation, and irrigation systems that add to a nation’s productive capacity. – In developing economies, government provision of public goods is highly deficient, and many socially useful projects cannot be successfully undertaken by the private sector.

Strategies for Economic Development A developing economy with insufficient human and physical capital faces some very basic trade-offs. Three of these trade-offs are: – Agriculture versus industry. – Exports versus import substitution. – Central planning versus the market.

Agriculture or Industry? Industry has some apparent attractions over agriculture: – The building of factories is an important step toward increasing the stock of capital. – Developed economies have experienced a structural transition from agriculture to industrialization and greater provision of services. However, industrialization in many developed countries has not brought the benefits that were expected.

Agriculture or Industry? The Structure of Production in Selected Developed and Developing Economies, 2001 COUNTRY PER CAPITA GROSS NATIONAL INCOME (GNI) PERCENTAGE OF GROSS DOMESTIC PRODUCT AGRICULTUREINDUSTRYSERVICES Tanzania $ Bangladesh China Thailand1, Colombia1, Brazil3, Korea9, United States34, Japan35, Source: World Bank,

Exports or Import Substitution? Import substitution is an industrial trade strategy that favors developing local industries that can manufacture goods to replace imports.

Exports or Import Substitution? The import-substitution strategy has failed almost everywhere for the following reasons: – Domestic industries, sheltered from international competition, develop major economic inefficiencies. – Import substitution encouraged the production of capital- intensive production methods, which limited the creation of jobs. – The cost of the resulting output was far greater than the price of that output in world markets.

Exports or Import Substitution? Export promotion is a trade policy designed to encourage exports. – Several countries including Japan, the “four little dragons,” Brazil, Colombia, and Turkey, have had some success with outward-looking trade policy. – Government policies to promote exports include subsidies to export industries and the maintenance of a favorable exchange rate environment.

Central Planning or the Market? Today, planning takes many forms in developing nations. The economic appeal of planning lies in its ability to channel savings into productive investment and to coordinate economic activities that otherwise might not exist. The reality of central planning is that it is technically difficult, highly politicized, and difficult to administer.

Central Planning or the Market? Market-oriented reforms recommended by international agencies include: – the elimination of price controls, – privatization of state-run enterprises, and – reductions in import restraints.

Central Planning or the Market? The International Monetary Fund is an international agency whose primary goals are to stabilize international exchange rates and to lend money to countries that have problems financing their international transactions.

Central Planning or the Market? The World Bank is an international agency that lends money to individual countries for projects that promote economic development.

Growth Versus Development: The Policy Cycle Structural adjustment is a series of programs in developing nations designed to: 1.reduce the size of their public sectors through privatization and/or expenditure reductions, 2.decrease their budget deficits, 3.control inflation, and 4.encourage private saving and investment through tax reform.

Issues in Economic Development The growth of the population in developing nations is about 1.7 percent per year, compared to only 0.5 percent per year in industrial market economies. Thomas Malthus, England’s first professor of political economy, believed populations grow geometrically. He believed that due to the diminished marginal productivity of land, food supplies grow much more slowly.

The Growth of World Population, Projected to 2020 A.D.

Population Growth Population growth is determined by the relationship between births and deaths. The fertility rate, or birth rate, equals: The mortality rate, or death rate, equals:

Population Growth The natural rate of population increase is the difference between the birth rate and the death rate. It does not take migration into account. Any nation that wants to slow its rate of population growth will probably find it necessary to have in place economic incentives for fewer children as well as family planning programs.

Developing-Country Debt Burdens Debt rescheduling is an agreement between banks and borrowers through which a new schedule of repayments of the debt is negotiated; often some of the debt is written off and the repayment period is extended. A stabilization program is an agreement between a borrower country and the International Monetary Fund in which the country agrees to revamp its economic policies to provide incentives for higher export earnings and lower imports.

Political Systems and Economic Systems: Socialism, Capitalism, and Communism Democracy and dictatorship refer to political systems. – A democracy is a system of government in which ultimate power rests with the people, who make governmental decisions either directly through voting or indirectly through representatives. – A dictatorship is a political system in which ultimate power is concentrated in either a small elite group or a single person.

Political Systems and Economic Systems: Socialism, Capitalism, and Communism Two major economic systems have existed: socialism and capitalism. A socialist economy is one in which most capital— factories, equipment, buildings, railroads, and so forth—is owned by the government rather than by private citizens. Social ownership is another term that is used to describe a socialist economy.

Political Systems and Economic Systems: Socialism, Capitalism, and Communism Two major economic systems have existed: socialism and capitalism. A capitalist economy is one in which most capital is privately owned.

Political Systems and Economic Systems: Socialism, Capitalism, and Communism Communism is an economic system in which the people control the means of production (capital and land) directly, without the intervention of a government or state.

Political Systems and Economic Systems: Socialism, Capitalism, and Communism Comparing economies today, the real distinction is between centrally planned socialism and capitalism, not between capitalism and communism. No pure socialist economies and no pure capitalist economies exist. The United States supports many government enterprises, including the postal system, although public ownership is the exception.

Political Systems and Economic Systems: Socialism, Capitalism, and Communism Whether particular kinds of political systems tend to be associated with particular kinds of economic systems is debatable. There are capitalist economies with democratic political institutions; socialist economies that maintain strong democratic traditions; and democratic countries with strong socialist institutions. At the heart of both the market system and democracy is individual freedom.

Central Planning Versus the Market Just as there are no pure capitalist and no pure socialist economies, there are no pure market economies and no pure planned economies. A market-socialist economy is an economy that combines government ownership with market allocation.

Easterly Policy doesn’t matter for growth, except don’t have bad policies. – Stay away from extreme inflation – etc

Review Terms and Concepts aggregate production function aggregate production function consumer sovereignty consumer sovereignty economic growth economic growth industrial policy industrial policy innovation invention labor productivity labor productivity modern economic growth modern economic growth productivity of an input productivity of an input

Review Terms and Concepts brain drain brain drain capital flight capital flight capitalist economy capitalist economy communism debt rescheduling debt rescheduling export promotion export promotion fertility rate fertility rate import substitution import substitution International Monetary Fund, IMF International Monetary Fund, IMF market-socialist economy market-socialist economy mortality rate mortality rate natural rate of population increase natural rate of population increase shock therapy shock therapy social overhead capital social overhead capital socialist economy socialist economy stabilization program stabilization program structural adjustment structural adjustment tragedy of commons tragedy of commons vicious-circle-of-poverty hypothesis vicious-circle-of-poverty hypothesis World Bank World Bank

The Transition to a Market Economy Economists generally agree on six basic requirements for a successful transition from socialism to a market-based system: 1. macroeconomic stabilization; 2. deregulation of prices and liberalization of trade; 3. privatization of state-owned enterprises and development of new private industry;

The Transition to a Market Economy Economists generally agree on six basic requirements for a successful transition from socialism to a market-based system: 4. the establishment of market-supporting institutions, such as property and contract laws, accounting systems, and so forth; 5. a social safety net to deal with unemployment and poverty; and 6. external assistance.

The Transition to a Market Economy The tragedy of commons is the idea that collective ownership may not provide the proper private incentives for efficiency because individuals do not bear the full costs of their own decisions but do enjoy the full benefits.

The Transition to a Market Economy Shock therapy is the approach to transition from socialism to market capitalism that advocates rapid deregulation of prices, liberalization of trade, and privatization. Advocates of a gradualist approach believe that the best course of action is to build up market institutions first, gradually decontrol prices, and privatize only the most efficient government enterprises.