Chapter 7 Economic Growth © 2015 Pearson Education, Ltd.

7.1 The Power of Economic Growth 7.2 How Does a Nation's Economy Grow?
Chapter Outline 7.1 The Power of Economic Growth 7.2 How Does a Nation's Economy Grow? EBE Why are you so much more prosperous than your great-great-grandparents were? 7.3 The History of Growth and Technology 7.4 Growth, Inequality, and Poverty © 2015 Pearson Education, Ltd.

Sustained economic growth relies on technological progress.
Key Ideas Economic growth measures how much (real) GDP per capita grows over time. Today’s high levels of GDP per capita in many nations are a result of rapid economic growth over the last two centuries. Sustained economic growth relies on technological progress. © 2015 Pearson Education, Ltd.

Economic growth is a powerful tool for poverty reduction.
Key Ideas There are sizable differences in the historical growth rates of different economies, which are largely responsible for their differences in the levels of GDP per capita. Economic growth is a powerful tool for poverty reduction. © 2015 Pearson Education, Ltd.

Economic growth, or growth
7.1 The Power of Economic Growth Economic growth, or growth The increase in GDP per capita of an economy. In 1820, the level of GDP per capita was $1,858. In 1950, the level of GDP per capita was $13,056. In 2012, the level of GDP per capita was $45,336. Instructor: The GDP statistics are recorded in 2005 constant dollars, where the effects of inflation have been removed. © 2015 Pearson Education, Ltd.

7.1 The Power of Economic Growth
Instructor: The vertical axis has a proportional scale, where the distance between $500 and $2,500 is the same as that between $2,500 and $12,500. Exhibit 7.1 GDP per Capita in the United States (2005 constant dollars) © 2015 Pearson Education, Ltd.

Growth rate The change in a quantity between two dates, relative to the beginning date (baseline). Let us choose two dates, t and t+1, and denote GDP per capita in those dates as y and Instructor: the numerator is the change in the quantity of GDP per capita between time t+1 and t, and the denominator is the level of GDP per capita at time t. © 2015 Pearson Education, Ltd.

U.S. Annual Growth Rate of GDP per Capita
7.1 The Power of Economic Growth U.S. Annual Growth Rate of GDP per Capita Instructor: the first growth rate calculation is the one done in the book and the second growth rate calculation uses the most recent BEA data adjusted to 2005 dollars. © 2015 Pearson Education, Ltd.

The annual growth rate of GDP per capita of the U.S. economy is mostly positive but can be negative, as it was in 2007–2008 and 2008–2009. The average annual growth rate of the U.S. economy between 1950 and 2012 is 2.03%. © 2015 Pearson Education, Ltd.

Instructor: The red line is the average growth rate of GDP per capita of 2.03%. Exhibit 7.2 The Annual Growth Rate of GDP per Capita in the United States Between 1950 and 2012 (2005 constant dollars) © 2015 Pearson Education, Ltd.

Suppose Y in 2010 is growing at 10% each year.
7.1 The Power of Economic Growth Suppose Y in 2010 is growing at 10% each year. What would be the value of Y in 2015? You earn 10% each year, so the total increase would be 0.10 × 15 = 1.50 in 15 years: Y2015 = Y2000 × 1.50 … WRONG © 2015 Pearson Education, Ltd.

With exponential growth, new growth builds on past growth, and its effects compound: Y2001 = Y2000 × 1.10 Y2002 = Y2001 × 1.10 = Y2000 × × 1.10 = Y2000 × 1.102 Y2003 = Y2002 × 1.10 = Y2000 × × 1.10 = Y2000 × 1.103 Y2004 = Y2003 × 1.10 = Y2000 × × 1.10 = Y2000 × 1.104 Instructor: We are using the equation above in the second equality to rewrite the level of real GDP in terms of the initial 2000 value. © 2015 Pearson Education, Ltd.

With exponential growth, new growth builds on past growth, and its effects compound: Y2005 = Y2000 × = Y2000 × > Y2000 × 0.50 Y2010 = Y2000 × = Y2000 × > Y2000 × 1.00 Y2015 = Y2000 × = Y2000 × > Y2000 × 1.50 Instructor: The inequality in each equation is comparing the compounded return to the simple linear return. © 2015 Pearson Education, Ltd.

One implication of exponential growth is that it is much more convenient to use an axis with a proportional scale. A 10% growth rate starting from 1,000 will take us to 1,100, for a change of 100. A 10% growth rate starting from 10,000 will take us to 110,000, for a change of 10,000. © 2015 Pearson Education, Ltd.

Y2010 = $1,000 if annual growth is 0%
7.1 The Power of Economic Growth Consider three countries with the same starting level of GDP per capita, Y1810. What would be GDP per capita in 2010 (200 years) if each country grew at 0%, 1% , and 2%? Y2010 = $1, if annual growth is 0% Y2010 = $7, if annual growth is 1% Y2010 = $52, if annual growth is 2% Instructor: The formulas used is ($1,000)*(1+g)^200, where g is the growth rate. © 2015 Pearson Education, Ltd.

Let’s look at what exponential growth implies about the growth experiences of rich vs. poor countries and fast vs. slow growers. We use a 1960 to 2010 data set where GDP per capita is in PPP-adjusted 2005 constant dollars. © 2015 Pearson Education, Ltd.

Richest and Poorest Economies
7.1 The Power of Economic Growth Richest and Poorest Economies Real GDP per Capita Growth (%) 1960 2010 Luxembourg 17,601 75,589 2.91 Singapore 4,383 55,862 5.22 Norway 12,524 50,488 2.79 United States 15,398 41,365 2.00 Austria 15,256 41,114 1.98 Central African Rep. 968 589 –0.99 Niger 861 522 –1.00 Burundi 344 397 0.29 Zimbabwe 285 320 0.23 Dem. Rep. of Congo 696 241 –2.10 Instructor: The data for this slide are taken from the Penn World Tables The countries here are some but not all those in Exhibit 7.7. The calculation of an implied growth rate requires GDP per capita data for 2010 and That is why countries such as Qatar and United Arab Emirates are not present. © 2015 Pearson Education, Ltd.

Fastest- and Slowest-Growing Economies
7.1 The Power of Economic Growth Fastest- and Slowest-Growing Economies Real GDP per capita Growth (%) 1960 2010 Singapore 4,383 55,862 5.22 Botswana 674 9,676 5.33 South Korea 1,656 26,609 5.71 Taiwan 1,862 32,105 5.69 Equatorial Guinea 611 13,959 6.26 Guinea 915 788 ‒0.30 Madagascar 1,052 703 ‒0.81 Central African Rep. 968 589 ‒0.99 Niger 861 522 ‒10 Dem. Rep. of Congo 696 241 ‒2.10 Instructor: The data for this slide are taken from the Penn World Tables The countries here are some but not all those in Exhibit 7.7. The calculation of an implied growth rate requires GDP per capita data for 2010 and That is why countries such as Qatar and United Arab Emirates are not present. © 2015 Pearson Education, Ltd.

What about the implied average growth rates for all countries?
7.1 The Power of Economic Growth What about the implied average growth rates for all countries? The next slide shows that the majority of nations have experienced average annual growth in real GDP per capita of 1%‒3%. Instructor: Let’s look at what exponential growth implies about the growth experiences of our rich vs. poor countries. © 2015 Pearson Education, Ltd.

Instructor: The data for this slide are taken from the Penn World Tables 7.1. Exhibit 7.7 Average Growth Rates of GDP per Capita from 1960 to 2010 (PPP-adjusted 2005 constant dollars) © 2015 Pearson Education, Ltd.

What about the implied average growth rates for longer time periods?
7.1 The Power of Economic Growth What about the implied average growth rates for longer time periods? The Maddison Project, named after the late Angus Maddison, has estimated growth rates for numerous countries back to 1820 and beyond. We look at the implied growth rates for a few of these countries in the next slide. © 2015 Pearson Education, Ltd.

1820 1870 1920 1970 2010 (1820– 2010) (1920– 2010) U.K. 2,854 4,391 6,259 14,818 32,722 1.29 1.85 U.S. 1,873 3,364 7,641 20,684 41,962 1.65 1.91 Argentina 1,374 2,020 4,780 10,049 14,115 1.23 1.20 Hong Kong 846 940 1,760 7,838 42,283 1.92 3.56 Chile 832 1,776 3,810 7,199 19,106 1.80 South Korea 461 464 839 2,983 29,864 2.22 4.05 The data for this slide are taken from the Maddison Project. The units have been converted to real 2005 dollars. Instructor: In 1820, the United Kingdom was 1st, Holland was 2nd, Italy was 3rd, the United States was 4th, Denmark was 5th, Austria was 6th, Uruguay was 7th, France was 8th, Spain was 9th, and Argentina was 10th…ahead of such countries as Canada, Australia, Ireland, Finland, Norway, and Sweden! Korea was dead last! © 2015 Pearson Education, Ltd.

There are two important take-aways from these growth tables.
7.1 The Power of Economic Growth There are two important take-aways from these growth tables. © 2015 Pearson Education, Ltd.

Examples include Chile, Hong Kong, and South Korea.
7.1 The Power of Economic Growth Catch-up growth: Poor countries tend to grow faster, or “catch up,” to rich countries as they adopt the production and technologies of the richest countries. Examples include Chile, Hong Kong, and South Korea. As Argentina shows, however, catch-up growth is not guaranteed. © 2015 Pearson Education, Ltd.

Examples include the United Kingdom, United States, France, and Spain.
7.1 The Power of Economic Growth Sustained growth: Some countries experience positive and relatively steady growth rates over 50- , 100-, and even 200-year periods. Examples include the United Kingdom, United States, France, and Spain. © 2015 Pearson Education, Ltd.

How does a nation’s economy grow?
Let us return to the aggregate production function of Chapter 6: © 2015 Pearson Education, Ltd.

A nation can increase its GDP by:
7.2 How Does a Nation’s Economy Grow? A nation can increase its GDP by: Increasing its stock of physical capital, K Increasing the total efficiency units of labor, H Improving its technology, A © 2015 Pearson Education, Ltd.

Therefore, on the expenditure side, Y = C + I.
7.2 How Does a Nation’s Economy Grow? Capital Accumulation Consider a simply economy where there is no government nor exports nor imports, so that G = X = M = 0. Therefore, on the expenditure side, Y = C + I. Similarly, on the income side, Y = C + S. Setting the two equations together, I = S. Instructor: We start with capital accumulation first. The investment-saving identity at the bottom implies that all resources saved by households will be allocated to firms for investment in physical capital. © 2015 Pearson Education, Ltd.

Individual households decide how much of their income they consume and
7.2 How Does a Nation’s Economy Grow? Optimization: The Choice Between Saving and Consumption What determines aggregate saving, S? Individual households decide how much of their income they consume and how much they save. Consumption brings immediate happiness, while saving leads to future consumption and thus future happiness. © 2015 Pearson Education, Ltd.

7.2 How Does a Nation’s Economy Grow?
Optimization: The Choice Between Saving and Consumption The individual consumption-saving decision is ultimately an optimization problem where the relevant price is the interest rate. The sum total of these individual decisions determine the saving rate of the economy: © 2015 Pearson Education, Ltd.

Therefore, a constant or sustained growth rate cannot be achieved.
7.2 How Does a Nation’s Economy Grow? Physical capital accumulation by itself cannot generate sustained growth due to the diminishing marginal product of physical capital. Why? More and more capital will generate smaller and smaller increases in GDP. Therefore, a constant or sustained growth rate cannot be achieved. Instructor: Sustained growth refers to the growth process whereby GDP per capita grows at a positive and relatively stable rate for a relatively long period of time. © 2015 Pearson Education, Ltd.

Therefore, a constant or sustained growth rate cannot be achieved.
7.2 How Does a Nation’s Economy Grow? Similarly, population growth and education by themselves cannot generate sustained growth due to the diminishing marginal product of labor and diminishing marginal product of skills. Why? More and more labor will generate smaller and smaller increases in GDP. Therefore, a constant or sustained growth rate cannot be achieved. Instructor: Sustained growth refers to the growth process whereby GDP per capita grows at a positive and relatively stable rate for a relatively long period of time. © 2015 Pearson Education, Ltd.

Technological change The process in which new technologies and new goods and services are invented, introduced, and used in the economy. Such change can generate sustained growth. Instructor: Sustained growth refers to the growth process whereby GDP per capita grows at a positive and relatively stable rate for a relatively long period of time. © 2015 Pearson Education, Ltd.

Instructor: The reduction in the cost of light is an example of technological progress, where the decline in cost and thus the increase in benefit is exponential. Exhibit 7.9 The Real Price of Light over Time © 2015 Pearson Education, Ltd.

Technological change is more than a constant increase,
7.2 How Does a Nation’s Economy Grow? Technological change is more than a constant increase, such as 10 more units. Rather, it is exponential in that the rate of increase is approximately constant, such as 10%. Why? New innovations and technologies build on the existing stock of knowledge—“building on the shoulders of giants”—and thus are not subject to diminishing returns. © 2015 Pearson Education, Ltd.

Evidence-Based Economics Example
7 Economic Growth Evidence-Based Economics Example Question: Why are you so much more prosperous than your great-great-grandparents were? Data: The following table presents estimates of GDP per hour worked, physical capital stock per hour worked, and average years of schooling for 10-year periods starting in 1950. © 2015 Pearson Education, Ltd.

7 Economic Growth Instructor: The last decade is measured 2000–2007 to remove the impact of the Great Recession. Exhibit 7.10 (Columns 1-3) Contribution of Technology, Physical Capital, and Human Capital to the Growth of GDP per Hour Worked in the United States Between 1950 and 2007. © 2015 Pearson Education, Ltd.

7 Economic Growth Instructor: The growth contribution of physical capital in column 4 is the growth rate of physical capital from column 2 multiplied by the income share of physical capital, which is 1/3. The growth contribution of human capital in column 5 is the growth rate of Mincerian earnings derived from column 3 multiplied by the income share of human capital, which is 2/3. The growth contribution of technology in column 6 is defined as the remaining “unexplained” portion of growth in GDP per hour worked. It is therefore calculated as column 7 minus column 4 minus column 5. Exhibit 7.10 (Columns 4-7) Contribution of Technology, Physical Capital, and Human Capital to the Growth of GDP per Hour Worked in the United States between 1950 and 2007. © 2015 Pearson Education, Ltd.

7 Economic Growth Data: These data can then be converted into growth contributions of physical capital (K), human capital (H), and technology (A) to the annual growth rate of GDP per worker. © 2015 Pearson Education, Ltd.

7 Economic Growth Instructor: The joint contribution of physical capital plus human capital has been relatively steady, at 0.9%‒to 1.2%. However, the contribution of technology has varied from a low of 0.45% in the 1980s to a high of 2.4% in the 1950s. Exhibit 7.11 Share of Technology, Physical Capital, and Human Capital in the Growth of GDP per Hour Worked in the United States Between 1950 and 2007 © 2015 Pearson Education, Ltd.

Evidence-Based Economics Example
7 Economic Growth Evidence-Based Economics Example Question: Why are you so much more prosperous than your great-great-grandparents were? Answer: In most decades, technology accounts for the bulk of growth in U.S. GDP per worker. Caveat: If we understate the contribution of physical or human capital to GDP, the contribution of technology may be exaggerated. Instructor: The growth contribution of technology in column 6 is defined as the remaining “unexplained” portion of growth in GDP per hour worked. Therefore, if the contributions of physical capital in column 4 and/or human capital in column 5 are too low, then the contribution of technology will be too high. © 2015 Pearson Education, Ltd.

Pre-modern times: up to 1800 Industrial Revolution: 1800 to 1820
7.3 The History of Growth and Technology The economic history of the world can be broken down into three distinct periods: Pre-modern times: up to 1800 Industrial Revolution: 1800 to 1820 Post-Industrial Revolution: 1820 to present © 2015 Pearson Education, Ltd.

7.3 The History of Growth and Technology
Instructor: This graph shows an estimate of world-wide real GDP per capita from AD 1 to 2010, taken from the Maddison Project. During the pre-modern period, there was essentially no growth in the world economy, as it went from $642 in AD 1 to $846 in The world economy then began to grow to $1,217 in 1870 to $2,124 in 1913 to $3,001 in 1940. Source: The Maddison Project, at © 2015 Pearson Education, Ltd.

Thomas Malthus, writing in 1798, argued that humankind was destined to live at the subsistence level—the minimum level of income per person necessary to survive. According to the Malthusian cycle, any increase in income per capita above the subsistence level would lead to higher fertility rates. © 2015 Pearson Education, Ltd.

The higher fertility rates would fuel higher population growth, which in turn would drive income per capita back down to the subsistence level. Without any technological advances, pre-modern times were stuck in the Malthusian cycle of little to no sustained growth in income per capita. © 2015 Pearson Education, Ltd.

Two trends led Britain and then other countries to break out of the Malthusian cycle. First, the introduction of new machines and methods of production (Industrial Revolution) created the technological progress necessary for sustained growth. The Industrial Revolution started in production and then moved on to transportation. © 2015 Pearson Education, Ltd.

The post-industrial Revolution period has experienced sustained growth in income per capita due to dramatic innovations in transportation, communications, electricity, and computers. © 2015 Pearson Education, Ltd.

We therefore must look at the income inequality of a nation.
7.4 Growth, Inequality, and Poverty GDP per capita is a measure of the average living standard of a nation but not the income of all individuals in that nation. We therefore must look at the income inequality of a nation. The following graph shows a measure of income inequality of the United States from 1910 to present. © 2015 Pearson Education, Ltd.

7.4 Growth, Inequality, and Poverty
Instructor: The figure shows the percentage of total income in the United States accruing to the top 10% of income earners. It is a measure of income inequality. Exhibit 7.12 Fraction of U.S. Aggregate Income Accruing to the Top 10% of Earners © 2015 Pearson Education, Ltd.

What, then, is the relationship between economic growth and inequality? The following graph plots the relationship between growth in GDP per capita and changes in the poverty rate (defined as the percentage of the population living under $1.25 per day). © 2015 Pearson Education, Ltd.

Instructor: The figure shows that there is a negative relationship between the change in the poverty rate (on vertical axis) and the average growth rate of GDP per capita (on the horizontal axis). Exhibit 7.13 The Relationship Between Growth and Change in Poverty in the Early 1990s and the Early 21st Century © 2015 Pearson Education, Ltd.

Although the negative relationship does not prove that growth causes declining poverty, it does show that economic growth can provide an effective way of reducing poverty. © 2015 Pearson Education, Ltd.

Chapter 7 Economic Growth © 2015 Pearson Education, Ltd.

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Chapter 7 Economic Growth © 2015 Pearson Education, Ltd.

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