1. Chapter 12 “Economic Growth”
MACROECONOMICS: EXPLORE & APPLY by Ayers and Collinge
Chapter 12 “Economic Growth”

2. Learning Objectives Identify the sources of economic growth.
Describe the role of savings and investment in the process of capital formation.
Analyze how taxation affects both savings and investment activity.
Provide justification for subsidized higher education.

3. Learning Objectives
Summarize new growth theory and supply side economics
Discuss the key role of labor productivity in economic growth.

4. 12.1 THE SEEDS OF ECONOMICS GROWTH
Economic growth is measured by the change in real GDP over time.
Sometimes a GNP measure is used instead.
Economies turn resources into outputs of greater value.
Over time the possibilities for doing so expand as the economy develops new technologies, and acquires new resources.

5. Sources of Economic Growth
Most U.S. economic growth is attributable to increases in labor and capital.
Both technological change and additional capital increase labor productivity.
Increases in labor productivity means that more GDP is produced for each hour worked by by the labor force.

6. Annualized Growth Rates by Presidency
YEARS
GROWTH RATE
Kennedy-Johnson
4.9
Nixon-Ford
3.0
Carter
2.7
Reagan
3.5
Bush 1
1.7
Clinton
3.7
Bush 2
(1)
2.5

7. Sources of Economic Growth
The growth rate increases in some years, decreases in some years, and even falls in other years because of economic slowdowns.
When recession begins, labor productivity tends to fall as aggregate demand and production decrease.
When recession nears it end, production at first increases, with no corresponding increase in employment, causing productivity to rise.

8. Sources of Economic Growth
Labor productivity is associated with the amount of capital – both physical and human – labor has at its disposal.
The creation and accumulation of new capital is termed capital formation.
Capital formation requires initiative, and in market economies entrepreneurs make these choices based on profitability judgments.

9. Nurturing Growth – Savings and Investment
Capital formation requires investment, which can be coordinated centrally through government.
Investment can also be a decentralized process that responds to supply and demand in the marketplace.
Investors finance the capital formation that is necessary to take advantage of market opportunities.

10. Nurturing Growth – Savings and Investment
Expand their scale of operations.
Implement better production techniques.
Produce new goods that their old factories are ill-suited to manufacture.
Firms invest when they wish to do any of the following:

11. Nurturing Growth – Savings and Investment
To acquire human capital, individuals invest in themselves.
Savings provides the capital for investment.
Government reduces private savings and investment in two ways.
It taxes away income that might be saved.
It taxes the return on investments.
In contrast, government also adds to investment.

12. Nurturing Growth – Savings and Investment
Without government, aggregate savings and investment
would be the same. With government the situation is
more complex because tax dollars can be directed towards
government investment or government consumption.
Investment + Government consumption = Savings + Taxation
or, equivalently,
Investment = Savings + Taxation - Government consumption

13. Nurturing Growth – Savings and Investment
Higher interest rates raise the cost of investing.
A crowding out effect occurs when government borrowing is in competition with private-sector borrowing, and thus can cause higher interest rates.
Higher interest rates decrease investment.

14. Nurturing Growth – Savings and Investment
Investment is also affected by the following factors..
Business confidence
Current economic growth
Opportunities presented by technological change
Increases in any of these variables would shift the investment demand curve to the right.
Decreases would shift the investment demand curve to the left.

15. The Equilibrium Interest Rate
Real
Interest
Rate
As the interest rate
gets lower, businesses
borrow more…
Supply of
savings
Demand for
investment
…and people
save less.
Actual
Interest
Rate
At equilibrium, the
amount borrowed
and saved is equal.
Actual savings
and investment
Savings and
investments

16. 12.2 INFLUENCING GROWTH THROUGH PUBLIC POLICY
Private investors assess the expected return, which is the value of the investment if successful, multiplied by the probability of success.
The actual return can be viewed as ex post, meaning after the fact.
Ex post, an investment might have turned out fabulously, or might have failed miserably.

17. The Incentive Effects of Taxation
In addition to regulation, taxes can also affect growth.
A tax on savings increases the market interest rate and discourages investment.
Taxing the return to savings shifts the supply of savings to the left.
There is concern over the low personal savings rate in the U.S. in recent years.

18. The Incentive Effects of Taxation
Investment is also discouraged by other taxes such as the tax on capital gains.
Capital gains represents the difference between the current market value of an investment and its purchase price.
The capital gains tax takes a percentage of this difference when the investment is sold.

19. Effects of the Income Tax
Supply of savings
Real
Interest
Rate
Supply of savings
A tax on savings
changes the market
equilibrium for savings
and investment.
Higher
interest
rate
Demand for
investment
Lower savings
and investment
Savings and
investment

20. Subsidizing Research and Development
An external benefit occurs when some benefits are received by third parties who are not directly involved in a decision, such as the decision to research or invest.
Research is aimed at creating new products or otherwise expands the frontiers of knowledge and technology.
Development occurs when that technology is embodied into capital or output.

21. Subsidizing Research and Development
External benefits are most prominent at the research stage.
Especially when the research involves the creation of knowledge that can be applied to the production of many different products.
It is difficult for any one investor or group of investors to assert property rights over the range of applications that can arise from basic advances in knowledge.
To correct this market failure the government subsidizes research.

22. Subsidizing Research and Development
Universities are often the source
of valuable research, subsidized
by government that companies
fear to undertake on their own.

23. 12.3 PROPERTY RIGHTS AND NEW GROWTH THEORY
The prospect for business profits in the future can lead to research and development in the present.
This idea is the cornerstone for what is called the new growth theory, which emphasizes the importance of new ideas in generating economic growth, and intellectual property rights in providing the profit incentive to generate those ideas.

24. 12.4 SUPPLY-SIDE POLICY
Those economist who particularly emphasize policy aimed at growth are called supply-side economist, or supply-siders for short.
Supply-siders focus on increasing the value of what the economy can produce in the long-run (the supply side) rather than on any desire to change consumer’s spending behavior (the demand side).
Supply-siders feel that the short-run business cycle will sort itself out over time as long as the government does not intrude.

25. Supply-Side Policy
The objective of supply-side policy is to ensure that output associated with full employment is as high as possible.
Supply-side policies are designed to increase productivity, such as through increasing capital formation.
Full-employment output will change in response to changes in structural features of the economy, including resources and technology.
Structural features also include government policies that change how workers and firms behave.

26. Supply-Side Policy Critics refer to supply-side policies as
trickle down economics. The term suggest
that the policies were intended to make the
rich richer, so that they might spend a bit more
and help the rest of us. This is not the process
intended by supply-siders, instead they aim at
increasing productivity, not spending.

27. Supply-Side Policy Long-run Aggregate supply Price level Real GDP
Supply siders aim to
get more output from
full employment
Full-employment output
Real GDP

28. The Laffer Curve
Increasing tax rates will increase tax revenues, but only up to a point.
After that point, higher tax rates are self-defeating and actually reduce tax revenues.
At a rate of 100 percent, there would be no point to earning any income at all.

29. The Laffer Curve
Tax
Revenue
Maximum Tax Revenue 0%
Tax rate
100%

30. How Technology Impacts Growth
The ‘new’ U.S. economy is characterized by the application of technology to increase business productivity.
The growth of computers in the workplace increases the productivity of labor.
Throughout history, the economy has been revitalized again and again by technologies like the railroad, the automobile, radio, television, and now the computer and the Internet.

31. Sources of Changes in United States Labor Productivity 1979-2000
Item
1970 to 1990
1990 to 1995
1995 to 2000
(1) Output per hour (labor productivity)
1.6
1.5
2.7
(2) Contribution of capital
0.8
0.5
1.1
(2a)Contribution of information technology capital
0.4
0.9
(2b) Contribution of other capital
0.3
0.1
0.2
(3) Contribution of labor
(4) Contribution of technological change and other factors
0.6
1.4

32. 12.5 EXPLORE & APPLY The New Economy – Is It Real?
In the 1990’s the “new economy” was characterized by the tremendous wealth creation in the Silicon Valley.
The new economy is characterized by the application of technology to increase business productivity.
The application of computer technology has been especially significant.

33. Terms Along the Way economic growth labor productivity
capital formation
crowding-out effect
expected return
actual return
capital gains
capital gains tax
external benefit
research
development
property rights
new-growth theory
supply-side economists

34. Test Yourself Technological change and additional capital
increase labor productivity.
decrease labor productivity.
have no effect on labor productivity.
affect labor productivity in unpredictable ways.

35. Test Yourself
2. U.S. economic growth
has generally been characterized by a 5 percent or more growth rate since the 1960’s.
varied with each president.
was on a downward trend in the 1990’s, but has recently reversed its course.
is no longer considered an important goal.

36. Test Yourself 3. Capital formation is also referred to as
property rights.
technology .
the real interest rate.
investment.

37. Test Yourself 4. Investment equals savings + taxation.
savings + taxation + government consumption.
savings + taxation – government consumption.

38. Test Yourself 5. Higher real interest rates
increase the amount of investment.
decrease the amount of investment.
have no effect on the amount of investment.
have varying and unpredictable effects on investment.

39. Test Yourself
6. The Laffer curve shows that the effect of increasing taxes too much is
less economic growth.
less tax revenue.
more unemployment.
that only the rich get richer.

40. “Money, Banking, and the Federal Reserve"
The End!
Next Chapter 13
“Money, Banking, and the Federal Reserve"