Notes appear on slides 4, 5, 6, 11, 52, and 53.

Notes appear on slides 4, 5, 6, 11, 52, and 53.

25 Economic Growth CHAPTER

C H A P T E R C H E C K L I S T When you have completed your study of this chapter, you will be able to Define and calculate the economic growth rate, and explain the implications of sustained growth. 1 Identify the main sources of economic growth. 2 Review the theories of economic growth that explain why growth rates vary over time and across countries. 3 Describe the policies that might speed economic growth. 4

25.1 THE BASICS OF ECONOMIC GROWTH
Economic growth is a sustained expansion of production possibilities measured as the increase in real GDP over a given period. Calculating Growth Rates Economic growth rate The rate of change of real GDP expressed as a percentage per year. Economic growth is an exciting topic for students. Provide this table: Year Average income (2000 dollars per person per year) ,521 ,000 ,000 ,100,000 The data for 1800 to 2000 are actual and the future data are hypothetical based on projecting the growth rate of the past 200 years a further 200 years into the future [Continued on next slide]

To calculate this growth rate, we use the formula: Growth of real GDP = Real GDP in current year Real GDP in previous year x 100 – For example, if real GDP in the current year is $8.4 trillion and if real GDP in the previous year was $8.0 trillion, then the growth rate of real GDP is Ask your class what kind of life people had in the year 1800 with an average income of $762 a year in current dollars. Answers will vary but many students are likely to respond that life was quite hard. Transportation was limited to horses, and meals were all prepared at home from scratch and cooked over an open fire. Medical care was quite meager (even the stethoscope was sixteen years away in the making) and entertainment was limited to books and song. In fact, very few people actually owned a book besides the Bible in 1800! By 1900 life was a bit better. The advent of the railroad made transportation much more practical and efficient. The potbelly stove was now available to cook meals and we had even conquered a few diseases along the way. Compare old jobs with the new by looking at the year 1900 versus today and the changes that have taken place with their development. Ask your students if they recognize the list of professions below. Make sure only to list the professions without the descriptions. Students will probably recognize a handful but there should be a good number that they have not heard of before. It makes for a great icebreaker when discussing how the economic landscape of the country has changed. [Continued on next slide] Growth of real GDP = $8.4 trillion – $8.0 trillion $8.0 trillion x 100 = 5 percent.

The standard of living depends on real GDP per person. Real GDP per person Real GDP divided by the population. The contribution of real GDP growth to the change in the standard of living depends on the growth rate of real GDP per person. Blacksmiths a person who works with iron Wainrights a maker and repairer of wagons Boilermakers a workman who makes, assembles or repairs boilers Founders someone who melts and pours metal into molds Coopers someone that makes or repairs wooden casks or tubs Potters someone that makes pottery Colliers a coal miner Tinsmiths a worker who makes or repairs things of sheet metal Millwrights someone who maintains and cares for mechanical equipment in a mill or factory Virtually all of these professions are gone today. Theyʹve been replaced by mechanics, pilots, electricians, computer programmers, software designers, chemists, and engineers. You can ask your class what significant product developments occurred over the last 100 years that have been widely diffused throughout the economy. Here is a short list to get things going: radio, television, radar, tape recorder, computer, satellites, lasers, jet engine, nuclear power, robots, camcorders, cell phones, fiber‐optic cables, VCRs, and last but not least the Internet. The bottom line is that our economy has evolved from one that required mostly muscle when we were farmers to machines during the industrial age and finally to reliance on know‐how and creativity in the information age. The fruits of economic growth are higher product quality, less physical effort in producing goods and services, and larger amounts of leisure time.

We use the above formula to calculate this growth rate, replacing real GDP with real GDP per person. Suppose, for example, that in the current year, when real GDP is $8.4 trillion, the population is 202 million. Then real GDP per person is $8.4 trillion divided by 202 million, which equals $41,584. And suppose that in the previous year, when real GDP was $8.0 trillion, the population was 200 million. Then real GDP per person in that year was $8.0 trillion divided by 200 million, which equals $40,000.

Use these two values of real GDP per person in the growth formula to calculate the growth rate of real GDP per person. It is Growth rate of real GDP per person $41,584 – $40,000 $40,000 x 100 = 4 percent. =

The growth rate of real GDP per person can also be calculated by using the formula: Growth of real GDP per person Growth rate of real GDP Growth rate of population – = Growth of population 202 million – 200 million 200 million x 100 = 1 percent. =

Growth of real GDP per person 5 percent – 1 percent = 4 percent. = This formula makes it clear that real GDP per person grows only if real GDP grows faster than the population grows. If the growth rate of the population exceeds the growth of real GDP, real GDP per person falls.

The Magic of Sustained Growth Sustained growth of real GDP per person can transform a poor society into a wealthy one. The reason is that economic growth is like compound interest. Rule of 70 The number of years it takes for the level of any variable to double is approximately 70 divided by the annual percentage growth rate of the variable. Ask the students if the economy will grow dramatically differently if the growth rate is 3 percent or 5 percent. Students will probably say that it won’t make much difference. But, counter that over longer periods of time it can make a substantial difference. You can demonstrate this fact with a few simple calculations. Assume a hypothetical economy that starts off with real GDP of $100 billion. The numbers in the table are the size of the economy in billions of dollars. What is instructive here is that small changes in the growth rate over short periods of time do not have much of an impact on the size of the economy. But small changes in growth rate over longer periods of time do. You can point out that the economy is almost at the same level at 5 percent growth after 10 years as it is at 3 percent after 20 years. In fact there is a very good historical example that you can point to that helps illustrate just how important small differences in economic growth can be. Since World War II the U.S. economy has grown at an average rate of approximately 3 percent a year. During the so‐called slow down of the 1970s the growth rate dropped by as much as half of its historical rate. Economists have estimated that this slow down has cost our economy at least three trillion dollars in lost output! You can explain that this is output that is irretrievably lost. That is, we cannot get it back.

Table 25.1 Growth Rates Growth rate Years for Example (percent level to per year) double U.S. real GDP per person China real GDP per person

25.2 SOURCES OF ECONOMIC GROWTH
To understand what determines the growth rate of real GDP, we must understand what determines the growth rates of the factors of production and rate of increase in their productivity. All the influences on real GDP growth can be divided into those that increase Aggregate hours Labor productivity

Aggregate Hours Over time, aggregate hours increase. This growth in aggregate hours comes from growth in the labor force rather than from growth in average hours per worker. While the participation rate has increased over the past few decades, it has an upper limit, and most of the growth of aggregate hours comes from population growth. So population growth is the only source of growth in aggregate labor hours that can be sustained over long periods.

Population growth brings economic growth, but it does not bring growth in real GDP per person unless labor becomes more productive. Labor Productivity Labor productivity is the quantity of real GDP produced by one hour of labor. It is calculated by using the formula: Real GDP Labor productivity = Aggregate hours

For example, if real GDP is $8,000 billion and if aggregate hours are 200 billion, then we can calculate labor productivity as 200 billion Labor productivity = $8,000 billion = $40 per hour You can turn this formula around and see that Real GDP = Aggregate hours x Labor productivity

When labor productivity grows, real GDP per person grows, so the growth in labor productivity is the basis of rising living standards. The growth of labor productivity depends on three things: Saving and investment in physical capital Expansion of human capital Discovery of new technologies

Saving and Investment in Physical Capital Saving and investment in physical capital increase the amount of capital per worker and increase labor productivity. Expansion of Human Capital Human capital—the accumulated skill and knowledge of people—comes from two sources: Education and training Job experience

Discovery of New Technologies To reap the benefits of technological change, capital must increase. Some of the most powerful and far-reaching technologies are embodied in human capital. For example, language, writing, and mathematics. But most technologies are embodied in physical capital.

Sources of Growth: A Summary Figure 25.1 shows the sources of economic growth. Real GDP growth depends on aggregate labor hours growth and on labor productivity growth.

Aggregate hours growth depends on Population growth The labor force participation rate Average hours per worker

Labor productivity growth depends on Physical capital growth Human capital growth Technological advances

25.3 THEORIES OF ECONOMIC GROWTH
The three growth theories that we study are: Classical growth theory Neoclassical growth theory New growth theory

Classical Growth Theory Classical growth theory The theory that the clash between an exploding population and limited resources will eventually bring economic growth to an end. Malthusian theory Another name for classical growth theory—named for Thomas Robert Malthus.

The Basic Idea Advances in technology and the accumulation of capital bring increased productivity and increased real GDP per person. Classical growth theory says that the increase in real GDP per person will be temporary because prosperity will induce a population explosion. The population explosion will decrease real GDP per person.

Classical Theory of Population Growth When the classical economists were developing their ideas about population growth, an unprecedented population explosion was under way. To explain the high rate of population growth, the classical economists used the idea of a subsistence real income (real GDP per person). In classical theory, when real income exceeds the subsistence real income, the population grows.

The increasing population decreases the amount of capital per hour of labor, so eventually labor productivity and real GDP per person decrease. So no matter how much technological change occurs, real income (real GDP per person) is always pushed back toward the subsistence level. This dismal implication led to economics being called “the dismal science.”

Figure 25.2 shows that with the wage rate above the subsistence wage, the population increases . 1. The supply of labor increases. 2. The wage rate falls. 3. Employment increases.

The population and the supply of labor keep increasing until the wage rate equals the subsistence wage rate.

4. The increase in employment … 5. Increases real GDP. The increase in population increases employment and real GDP and lowers the wage rate and real GDP per hour of work.

Real GDP per hour of work decreases because of diminishing returns. Diminishing returns are the tendency for each additional hour of labor employed to produce a successively smaller additional amount of output. So if the real wage rate exceeds the subsistence real wage rate, according to the classical theory, population growth brings a fall in the real wage rate and a fall in real GDP per hour of work.

Neoclassical Growth Theory Neoclassical growth theory The theory that real GDP per person will increase as long as technology keeps advancing. Neoclassical growth theory predicts that Real GDP growth rate will equals the population growth rate plus labor productivity growth. Real GDP per person will increase as long as technology keeps advancing—economic growth will persist.

Population Growth Two opposing economic forces influence population growth. As incomes increase, the birth rate decreases and the death rate decreases. These opposing forces are offsetting, so the rate of population growth is independent of the rate of economic growth. The historical population trends contradict the views of the classical economists.

Technological Change In the neoclassical theory, the rate of technological change influences the rate of economic growth, but economic growth does not influence the pace of technological change. Technological change results from chance. When we get lucky, we have rapid technological change. When we have bad luck, the pace of technological advance slows

The Basic Idea Technological advances bring profit opportunities. Businesses expand and new businesses are created to exploit the new technologies. Investment and saving increase, so capital per hour of labor increases. The economy enjoys increased prosperity and growth.

But will the prosperity last? And will the growth last? Neoclassical growth theory says that the prosperity will last but the growth will not unless technology keeps advancing. The prosperity persists because no population explosion occurs to lower real GDP per person.

But growth stops if technology stops advancing because capital accumulation brings diminishing returns, which slow the growth rate of real GDP and reduces saving and investment. Eventually, the growth rate of capital slows to that of the population and real GDP per person stops growing. A Problem with Neoclassical Growth Theory The theory does not explain what determines technological change.

New Growth Theory New growth theory The theory that our unlimited wants will lead us to ever greater productivity and perpetual economic growth. According to new growth theory, real GDP per person grows because of the choices people make in the pursuit of profit.

Choices and Innovation The new theory of economic growth emphasizes three facts about market economies: Human capital grows because of choices. Discoveries result from choices. Discoveries bring profit, and competition destroys profit.

Human Capital Growth and Choices People decide how long to remain in school, what to study, and how hard to study. Discoveries and Choices The pace at which new discoveries are made—and at which technology advances—is not determined by chance. The pace at which new discoveries are made depends on how many people are looking for a new technology and how intensively they are looking.

Discoveries and Profits The forces of competition squeeze profits, so to increase profit, people constantly seek either lower cost methods of production or new and better products for which people are willing to pay a higher price. Two other facts play a key role in the new growth theory: Many people can use discoveries at the same time. Physical activities can be replicated.

Figure 25.3 shows the effect of an increase in labor productivity. 1. Production function shifts upward and 2. The demand for labor increases.

3.The real wage rate rises and 4. The quantity of labor employed increases.

5.The increase in employment and 6. The increase in labor productivity increase real GDP.

Figure 25.4 illustrates new growth theory in terms of a perpetual motion machine. 1. People want a higher standard of living and are spurred by... 2. Profit incentives to make the... 3. Innovations that lead to...

4. New and better techniques and new and better products, which in turn lead to... 5. The birth of new firms and the death of some old firms, 6. New and better jobs, and... 7. More leisure and more consumption goods and services.The result is...

8. A higher standard of living. But people want a yet higher standard of living, and the growth process continues.

25.4 ACHIEVING FASTER GROWTH
Preconditions for Economic Growth Economic freedom is the fundamental precondition for creating the incentives that lead to economic growth. Economic freedom A condition in which people are able to make personal choices, their private property is protected, and they are free to buy and sell in markets. If you have technology available in your classroom, play a clip from one of the bands that played in the Live 8 concerts of July 2005 (for example, U2). Alternatively, play a clip of Bob Geldof or Bono (of U2) talking about the Live 8 concerts. Some of these can be found at the Live 8 website, (go to and scroll down to find film clips of Bono, Nelson Mandela, and others). Most students will recognize Bono and will be drawn in by music clips or photos of the concerts (photos can be found at This can lead to a discussion of the goal of Live 8 in trying to generate support for debt relief for poor nations before a meeting of the G8 countries (July 2005). Conduct a reality check with students that this is one of the big unanswered ‘questions’ in macroeconomics. There are a multitude of groups, individuals researchers, and governments trying to figure out how to help economies grow and to reduce poverty worldwide. Even the poorest of our students has little comprehension of what poverty truly is and what economic growth seeks to combat and can accomplish. You can give them a moving and in places shocking glimpse by asking them to “listen to the voices” at this World Bank Web page: [Continued on next slide]

Economic freedom requires the protection of private property — the factors of production and goods that people own. Property rights The social arrangements that govern the protection of private property. Economic freedom also requires free markets. The major obstacles to growth are political, and economists don’t know much about how to remove those political obstacles. You can give your students a glimpse of these obstacles in their worst form by reminding them of news video clips they’ve almost certainly seen of Kabul, Mogadishu, and other troubled cities in which the rule of law has completely broken down. Economists know a lot about how to make an economy grow if the preconditions are in place, but virtually nothing about how to bring those preconditions about. The three preconditions for growth—markets, property rights, and monetary exchange are all essential to create acceptable levels of risk and low enough transactions costs to justify investment, specialization, and exchange. If you want to spend time on it, you can generate an interesting discussion on whether what matters is the particular system of property rights, or just that they be clear, certain, and enforceable with reasonable cost—the concept of the rule of law. Most students have never realized that property rights are highly varied, and many fast growing economies have nothing like U.S. absolute property rights in land, for example. Most students can see immediately how investment in physical and human capital in the form of education and training contribute to growth. Some have more difficulty getting a clear view of the role of learning by doing and technical change, particularly the small continuous refinement and improvement to existing technology rather than the spectacular breakthroughs. Much growth probably comes from the interaction of the last two, and this source of growth can be illustrated with a discussion of why firms offer incentives to workers to suggest improvements to working methods and procedures.

Policies to Achieve Faster Growth To achieve faster economic growth, we must increase The growth rate of capital per hour of labor or The growth rate of human capital or The pace of technological advance.

The main actions that governments can take to achieve these objectives are Create the incentive mechanisms Encourage saving Encourage research and development Encourage international trade Improve the quality of education

Create Incentive Mechanisms Economic growth occurs when the incentive to save, invest, and innovate is strong enough. These incentives exist only when private property is protected. Encourage Saving Saving finances investment, which brings capital accumulation. Tax incentives can encourage saving, increase the growth of capital, and stimulate economic growth.

Encourage Research and Development Everyone can use the fruits of basic research and development efforts. Because basic inventions can be copied, the inventor’s profit is limited and so the market allocates too few resources to this activity. Governments can direct public funds toward financing basic research, but it requires a mechanism for allocating public funds to their highest-valued use.

Encourage International Trade Free international trade stimulates economic growth by extracting all the available gains from specialization and trade. Improve the Quality of Education By funding basic education and by ensuring high standards in skills such as language, mathematics, and science, governments can contribute enormously to a nation’s growth potential.

How Much Difference Can Policy Make? A well-intentioned government cannot dial up a big increase in the growth rate. But it can pursue policies that will nudge the growth rate upward. And over time, the benefits from these policies will be large.

Economic Growth in YOUR Life
Think about the choices that you have made to increase your human capital. What can you do to speed up the rate at which your human capital grows? Will you continue to expand your human capital when you finish school and get a job? Think about the choices that you local government officials have made to increase economic growth. Do these choices create jobs? Do they create incentives for saving, investment, research, or improved education? What policies would you recommend to your local government officials to grow your local economy even faster?

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