1. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. Chapter 26 Long-Run Economic Growth

2. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 26-2 In this chapter you will learn to 3. Explain the main elements of Neoclassical growth theory. 2. Describe the four fundamental determinants of growth in real GDP. 1. Describe the costs and benefits of economic growth. 4. Describe new growth theories based on endogenous technical change and increasing returns. 5. Explain why resource exhaustion and environmental degradation create challenges for public policy directed at sustaining economic growth.

3. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 26-3 Sustained increases in Y* are a more powerful method of raising material living standards than the removal of recessionary gaps. Even small differences in annual growth rates can result in significant changes in living standards after many years. Consider GDP, per capita GDP, and GDP per worker. The Nature of Economic Growth

4. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 26-4 Figure 26.1 Three Aspects of Economic Growth

5. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 26-5 Table 26.1 The Cumulative Effect of Economic Growth

6. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 26-6 Benefits of Economic Growth 2. Alleviation of Poverty - many do not share directly in the growth - but redistribution is easier in a growing economy 1. Rising average Material living standards APPLYING ECONOMIC CONCEPTS 26.1 An Open Letter from a Supporter of the “Growth Is Good” School

7. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 26-7 Costs of Economic Growth 1. Sacrifice of Current Consumption - growth is often encouraged by increasing investment and saving - this requires less consumption (opportunity cost of economic growth)

8. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 26-8 Figure 26.2 The Opportunity Cost of Economic Growth

9. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 26-9 APPLYING ECONOMIC CONCEPTS 26.2 An Open Letter from a Supporter of the “Growth Is Bad” School 2. Social Costs of Growth - growth usually involves the displacement of some firms and workers - this process involves real transition costs The Opportunity Cost of Growth

10. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 26-10 Sources of Economic Growth 1. Growth in the labour force 2. Growth in human capital The four fundamental sources of economic growth are: 3. Growth in physical capital 4. Technological improvement Different theories emphasize different sources of growth.

11. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 26-11 Established Theories of Economic Growth Focus on the Long Run We focus on the long run when real GDP is equal to potential output, Y*. We hold Y* constant and let the interest rate be determined endogenously by desired saving and desired investment.

12. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 26-12 Investment, Saving, and Growth Our model has two parts: Investment — increases in the stock of capital — lead to increases in the future level of Y*. Saving by households (and firms) is used to finance this investment. - interest rate is the “price” that equilibrates this market

13. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 26-13 Firms’ investment demand is negatively related to the real interest rate. National saving = private saving + public saving NS = Y* - T - C + (T - G) = Y* - C - G If C is negatively related to the interest rate, then NS is positively related to the interest rate. Investment, Saving, and Growth

14. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 26-14 Figure 26.3 The Long-Run Connection between Saving and Investment

15. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 26-15 Figure 26.4 Increases in Investment Demand and the Supply of National Saving

16. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 26-16 Empirically, countries with high investment rates also have high growth rates. Figure 26.5 Cross-Country Investment and Growth Rates

17. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 26-17 Neoclassical Growth Theory This theory begins with the idea of an aggregate production function: GDP = F T (L,K,H) - L is the total amount of labour - K is the stock of physical capital - H is the quality of human capital - T is the state of technology F T reflects the assumption that changes in technology will change the production function.

18. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 26-18 Key assumptions about the aggregate production function are: 1. Diminishing marginal product of both K and L - when either factor is changed in isolation 2. Constant returns to scale - when both K and L are changed in equal proportions Properties of the Aggregate Production Function

19. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 26-19 Figure 26.6 The Aggregate Production Function and Diminishing Marginal Returns

20. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 26-20 Holding K constant, increases in L generate positive but diminishing increments to output. Figure 26.6 The Aggregate Production Function and Diminishing Marginal Returns

21. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 26-21 1. According to the law of diminishing returns, the MP of L eventually falls as each successive unit of L is used (for a fixed amount of other factors).  increases in population lead to increases in GDP but eventually to reductions in per capita GDP  falling material living standards Key Predictions of the Neoclassical Model

22. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 26-22 3. The assumption of constant returns to scale means that if K and L grow at the same rate there will be no improvements in material living standards.  GDP will grow but per capita GDP will be constant. 2. Diminishing MP of K also means that capital accumulation on its own brings smaller and smaller increases in real per capita GDP. Key Predictions of the Neoclassical Model

23. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 26-23 In the Neoclassical growth model, technological change is necessary for sustained growth in living standards. Much technological change is embodied in new capital equipment.  investment is crucial LESSONS FROM HISTORY 26.1 Should Workers Be Afraid of Technological Change? The Importance of Technological Change

24. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 26-24 Measuring technological change is difficult. Robert Solow (MIT) - his “growth accounting” method estimates technical change as the part of growth that is unexplained by capital accumulation or labor-force growth  the “Solow residual” Can We Measure Technological Change?

25. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 26-25 Endogenous Technological Change New growth theory emphasizes the process of innovation and the incorporation of new technology: learning-by-doing knowledge transfer market structure and innovation shocks and innovation New Growth Theories

26. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 26-26 Increasing Marginal Returns New growth theories also emphasize the possibility that each new increment of investment is more productive than the last. - contrasts with the Neoclassical assumption of diminishing marginal returns. The sources of increasing returns usually fall into one of two categories: market-development costs increasing returns to knowledge

27. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 26-27 Are there Limits to Growth? Resource Exhaustion Current technology and resources could not support the entire world’s population at the average U.S. living standard. - but absolute limits to growth may not be relevant - technology is constantly improving, suggesting that living standards can continually improve - but technological improvements are not automatic — they do not “just happen”

28. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 26-28 Pollution Conscious management of pollution was unnecessary when the world’s population was one billion people, but such management has now become a pressing matter. Conclusion Growth can help the world address many problems. But further growth must be sustainable growth, which should be based on knowledge-driven technological change. Are there Limits to Growth?