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W H AT I S E C O N O M I C S ? 49 ECONOMIC GROWTH** The Big Picture Where we have been: Chapter focuses on economic growth It uses the definitions and concepts of aggregate income and real GDP presented in Chapter as well as tying economic growth in the macroeconomy to the PPF of Chapter Where we are going: Chapter is the first of four chapters that examine the economy in the long run when the economy is at full employment The following chapters focus on finance and investment, money and the price level, and the exchange rate and balance of payments After these chapters the next section examines macroeconomic fluctuations by developing the AS-AD model The material presented in Chapter provides the long run fundamental variables and results that need to be remembered as various other models are developed in future chapters Chapter (and Chapter 7) is particularly useful in Chapter 13 when the supply-side effects of fiscal policy are covered N e w i n t h e Tw e l f t h E d i t i o n The chapter’s content and coverage are about the same as the 11 th edition All the data are updated through 2014 The Worked Problem gives data about China’s real GDP and population in two years and then asks the students to calculate the growth rate of China’s real GDP growth rate and its standard at living The question also asks the students to use the Rule of 70 to approximate how long it will take for China’s standard of living to double The solutions work step-by-step through the calculations necessary to answer the questions To include the new Worked Problem without lengthening the chapter, some problems have been removed from the Study Plan Problem and Applications These problems are in the MyEconLab and are called Extra Problems 49 Lecture Notes Economic Growth You can start your discussion of this chapter by listing on the board or on an overhead various countries ranked from highest per capita real GDP to lowest It is a real eye opener for students to consider income per person because it really shows how fortunate we are in the United States Tell your students that in the 1960s countries like Hong Kong, Singapore and Japan used to rank around where China ranks today Explain that this extraordinary growth is part of what motivated economists over the last 20-30 years to try to deduce how this type of growth can occur Is it possible the United States could something differently to grow at those growth rates? Is the neoclassical model correct in its prediction that there will be a global equilibrium in which all nations have the same real GDP per person? Then leave your students with the fact that China is 200 times the population of Hong Kong and times the population of the United States This brings the obvious question: Should we be concerned? Economic growth leads to large changes in standards of living from one generation to the next Economic growth rates vary across countries and across time There are different economic theories to explain these variations in growth rates I The Basics of Economic Growth The economic growth rate is the annual percentage change of real GDP This growth rate is equal to: Real GDP growth rate = Real GDP in current year Re al GDP in past year 100 Re al GDP in past year The standard of living depends on real GDP per person, which is real GDP divided by the population The growth rate of real GDP per person can be calculated using the formula above, though substituting real GDP per person The growth rate of real GDP per person also approximately equals the growth rate of real GDP minus the population growth rate Real GDP can increase for two distinct reasons: The economy might be returning to full employment in an expansion phase of the business cycle or potential GDP might be increasing The movement from point A to point B reflects an expansion phase of the business cycle It occurs with no change in production possibilities Such an expansion is not economic growth The increase in aggregate production reflected by the movement from point B on PPF0 to point C on PPF1 is economic growth —it reflects an expansion of production possibilities shown by an outward shift of the PPF The Rule of 70 is useful for determining how long it will take for a variable to double The Rule of 70 states that 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 ECONOMIC GROWTH Run through an example of the rule of 70 that does not relate to economic growth Examples: If tuition rates rise at percent per year, how long will it take it to double? 70/6 = 11.67 years If you invest $10,000 at 12 percent interest, how long will it take to double your money? 70/12 = 5.83 years Compound Interest: You can reinforce the importance of economic growth by relating the fact that if real GDP per person had grown just 0.25 percentage points faster between 1960 and the present, every household today, on average, would have almost $12,000 more income (every person would have $4,500 more) If real GDP per person had grown percentage point faster between 1960 and the present, every household today, on average, would have $50,000 more income (every person would have $21,200 more).To make concrete just how much better off we would have been, get the students to list what they would buy with an extra $21,200 a year II Long-Term Growth Trends Long-Term Growth in the U.S Economy The growth of real GDP per person in the United States has fluctuated but has averaged percent per year over the last century The growth rate was 1.8 percent prior to the Great Depression and 2.1 percent after World War II Real GDP Growth in the World Economy Economic growth varies across countries Among richest countries, there seems to be some convergence of real GDP per person but most other countries show less evidence of convergence The “Asian Miracle” is the fast rate of convergence for Hong Kong, Singapore, Taiwan, Korea, and China Is there convergence or divergence in standards of living? What is the role of economic growth for economic inequality? These are highly controversial questions Most antiglobalization activists treat it as incontrovertible that economic growth creates higher inequality But this view is likely incorrect First, there has been a general convergence of standards of living over the past 50 years This fact is in part the result of economic growth in China with a population that accounts for close to one-fifth of humanity Second, while some nations have fallen behind, those less developed countries that have grown fastest are those that have been most involved in “globalization” by becoming more integrated into global markets for goods and capital The policy suggestions of the anti-globalization movement, such as reducing foreign trade and international capital mobility or even abandoning capitalism, property rights, and markets are the policies that are currently most practiced in countries that have grown the slowest This result might not be a coincidence III How Potential GDP Grows Potential GDP is the amount of real GDP that is produced when the quantity of labor employed is the full-employment amount To determine potential GDP we use the aggregate production function and the aggregate labor market The Aggregate Production Function The aggregate production function is the relationship between real GDP and the quantity of labor employed when all other influences on production remain the same The figure shows an aggregate production function 57 58 CHAPTER The additional real GDP produced by an additional hour of labor when all other influences on production remain the same is subject to the law of diminishing returns, which states that as the quantity of labor increases, other things remaining the same, the additional output produced by the labor decreases The production function in the figure shows the law of diminishing returns because its shape demonstrates that as additional labor is employed, the additional GDP produced diminishes The Labor Market The Demand for Labor The demand for labor is the relationship between the quantity of labor demanded and the real wage rate The real wage rate equals the money wage rate divided by the price level The real wage rate is the quantity of goods and services that an hour of labor earns and the money wage rate is the number of dollars that an hour of labor earns Because of diminishing returns, firms hire more labor only if the real wage falls to reflect the fall in the additional output the labor produces There is a negative relationship between the real wage rate and the quantity of labor demanded so, as illustrated in the figure, the demand for labor curve is downward sloping The Supply of Labor The supply of labor is the relationship between the quantity of labor supplied and the real wage rate An increase in the real wage rate influences people to work more hours and also increases labor force participation These factors mean there is a positive relationship between the real wage rate and the quantity of labor supplied so, as illustrated in the figure, the supply of labor curve is upward sloping Labor Market Equilibrium and Potential GDP In the labor market, the real wage rate adjusts to equate the quantity of labor supplied to the quantity of labor demanded In equilibrium, the labor market is at full employment In the figure, the equilibrium quantity of employment is 200 billions of hours per year Potential GDP is the level of production produced by the full employment quantity of labor In combination with the production function shown in the previous figure, the labor market equilibrium in the figure of 200 billion hours per year means that potential GDP is $13 trillion What Makes Potential GDP Grow? Potential GDP grows when the supply of labor grows and when labor productivity grows Growth of the Supply of Labor The supply of labor increases if average hours per worker increases, if the employment-to-population ratio increases, or if the working-age population increases Of these factors, in the United States over the past years the first two have offset each other Only increases in the working-age population can cause persisting economic growth Persisting increases in the working-age population result from population growth ECONOMIC GROWTH An increase in population increases the supply of labor, which shifts the labor supply curve rightward The real wage rate falls and the quantity of employment increases The increase in employment leads to a movement along the production function to a higher level of potential GDP An Increase in Labor Productivity An increase in labor productivity increases the demand for labor and shifts the production function upward As the top figure illustrates, the increase in the demand for labor from LD0 to LD1 raises the real wage rate, from $20 to $30 per hour in the figure, and increases the level of employment, from 200 billion hours per year to 300 billion hours per year The bottom figure shows that the production function has shifted upward, from PF0 to PF1 Combined with the increase in employment to 300 billion hours per year, the increase in labor productivity increases potential GDP from $10 trillion to $15 trillion An increase in labor productivity leads to an increase in real GDP per person and increases the standard of living IV Why Labor Productivity Grows Preconditions for Labor Productivity Growth The institutions of markets, property rights, and monetary exchange create incentives for people to engage in activities that create economic growth and are preconditions for growth in labor productivity Market prices send signals to buyers and sellers that create incentives to increase or decrease the quantities demanded and supplied Property rights create incentives save and invest in new capital and develop new technologies Monetary exchange creates incentives for people to specialize and trade Persistent growth requires that people face incentives to create: Physical Capital Growth: Saving and investing in new capital expands production possibilities Human Capital Growth: Investing in human capital speeds growth because human capital is a fundamental source of increased productivity and technological advance Technological Advances: Technological change, the discovery and the application of new technologies and new goods, has made the largest contribution to economic growth The Causes of Economic Growth: A First Look; The limits of economics 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, 59 60 CHAPTER 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 preconditions The three preconditions for growth—markets, property rights, and monetary exchange—are all essential to create acceptable levels of risk and low enough transaction 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 Interactions of sources of growth 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 V Is Economic Growth Sustainable? Theories, Evidence, and Policies Classical Growth Theory Classical growth theory is the view that real GDP growth is temporary and that when real GDP per person rises above the subsistence level, a population explosion eventually brings real GDP per person back to the subsistence level A problem with the classical theory is that population growth is independent of economic growth rate Classical growth theory is based on the work of Thomas Malthus, an economist from the early nineteenth century Very few modern-day economists would refer to themselves as Malthusians But, as the textbook says, there are many other people today who are Malthusians The persistence of this viewpoint represents what one can only refer to as the triumph of despair over experience At some point in history, Malthusian theory might have been applicable But certainly since the industrial revolution, parents have chosen to concentrate on the quality of children not the quantity And this shift in emphasis only gets stronger as economic growth advances Thus, the assumption that the population growth rate is primarily determined by economic growth with a positive relationship has no basis in reality Indeed, some of the richest countries in the world, such as Sweden and Japan, have some of the lowest birth rates Neoclassical Growth Theory Neoclassical growth theory is the proposition that the real GDP per person grows because technological change induces a level of saving and investment that makes capital per hour of labor grow A technological advance increases productivity Real GDP per person increases The technological advances increase expected profit Investment and saving increase so that capital increases The increase in capital raises real GDP per person As more capital is accumulated, eventually projects with lower rates of return must be undertaken so that the incentive to invest and saving decrease Eventually capital stops increasing so that economic growth stops The improvement in technology permanently increases real GDP per person ECONOMIC GROWTH A problem with the neoclassical theory is that it predicts that real GDP per person in different nations will converge to the same level But in reality, convergence does not seem to be taking place for all nations An Economics in Action detail discusses the key role played by intellectual property rights The section focuses on the start of the Industrial Revolution and looks at how England’s patent system helped sustain the revolution New Growth Theory New growth theory holds that real GDP per person grows because of the choices people make in the pursuit of profit and that growth can persist indefinitely The theory emphasizes that discoveries result from choices, discoveries bring profit, and competition then destroys the profit It also stresses that knowledge can be used by everyone at no cost and knowledge is not subject to diminishing returns The ability to innovate means new technologies are developed and capital accumulated as in the neoclassical model The production function shifts upward Real GDP per person increases The pursuit of profit means that more technological advances occur and the production function continues to shift upward Nothing stops the upward shifts of the production function because the lure of profit is always present The ability to innovate determines how capital accumulation feeds into technological change and the resulting growth path for the economy Productivity and real GDP constantly grow The Classical Model Explain that more capital and more productive capital that uses new technologies increases productivity, shifts the production function upward, and shifts the demand for labor curve rightward Real GDP increases and on the average, the real wage rate rises You might then spend a few minutes agreeing that capital accumulation and technological change decrease the demand for the labor that the new capital replaces But it increases the demand for other types of labor—complementary labor People must acquire more skill—some people learn to work with the new capital, some learn how to maintain it in good condition, some learn how to build it, some learn how to market and sell it, some learn to design new ways of using it, some work on thinking up new goods and services to produce with it, and so on All of these people are more productive that they were before New technologies that create new products have even more obvious effects on productivity The development of the CD in the early 1980s is a good example Suddenly thousands of people became very productive converting the heritage of recorded music into digital format, cleaning up the sound, and making and selling millions of CDs The same type of thing is now happening with the conversion of media to digital formats for all of our digital devices Historical development of theories and an aside The three growth theories studied in this chapter—classical, neoclassical, and new—are presented in historical order Point out this fact to the students to emphasize and illustrate how economic theory builds on itself (An aside for you, not your students: Note that the chapter skips the Keynesian era HarrodDomar model The main reason for this omission is that these models were quickly shown to be in error and never formed the basis of a seriously proposed growth theory Based on fixed coefficients and fixed saving rates, the Harrod-Domar model produces either secular stagnation or secular inflation Neither phenomenon occurs in real economies Solow’s neoclassical model was developed, historically, to show the error of the Harrod-Domar 61 62 CHAPTER model, but the neoclassical model also builds naturally on its classical predecessor, and that is the sequence in the textbook.) Classical theory Start with the classical theory The classical theory of growth takes technological change as exogenous, essentially ignores the role of capital (as a result of the era in which it was developed), and assumes that population growth increases when income increases (also as a result of the era in which it was developed) As a result, the conclusions from the classical theory are “dismal” indeed! Some students find it interesting to know that Thomas Malthus, most closely associated with the population part of this theory, was a clergyman, but was also the first person in the Anglophone world to hold the title of Professor of Political Economy (at the East India College) Economists came to realize that capital accumulation and technological change were important parts of the growth process They also came to understand that population growth does not necessarily increase with income Hence the stage was set for the neoclassical theory Neoclassical theory Neoclassical theory follows the classical theory by taking technological growth as exogenous It differs insofar as it assumes that population growth also is exogenous The major difference is that neoclassical theory stresses the role played by technological change and how it influences saving and capital accumulation So of the two differences between neoclassical and classical growth theory, the first—the different assumptions about how population growth is determined—reflects an advance in empirical knowledge of the relationship between population growth and income The second difference—the importance given to technological change, saving, and capital—shows how the neoclassical theory built on the simpler classical model New growth theory Neoclassical theory also is incomplete because the primary engine of economic growth, technology, is exogenous New growth theory attempts to overcome this weakness It still uses many of the insights of the neoclassical theory by emphasizing the role of capital accumulation and assuming that population growth is exogenous But the new growth theory builds on neoclassical theory by examining more closely the role of technology and the factors that influence technological advances Giving the students this type of broad overview before presenting the details of the different models is important because it, along with the text’s outstanding overview, allows the students to see the forest as well as the trees This knowledge not only helps them understand the particular models, but it also helps them gain an appreciation of how economics progresses (Of course, progress is hardly as steady as the students might believe; for instance, Pigou and Ramsey presented important papers about growth in the early part of the twentieth century, but, nonetheless, progress has been made.) The Empirical Evidence on the Causes of Economic Growth Economists have studied the growth rate data for more than 100 countries for the period since 1960 and explored the correlations between the growth rate and more than 60 possible influences on it The conclusion of this data crunching is that most of these possible influences have variable and unpredictable effects, but a few of them have strong and clear effects Amongst the strongest are: International Trade: Nations that are open to trade grow more rapidly Investment: Nations that have more investment in human capital and physical capital grow more rapidly Market Distortions: Nations that have more exchange rate controls, price controls, and black markets grow more slowly Economic System: Capitalist nations grow more rapidly Politics: Nations that support the rule of law and protect civil liberties grow more rapidly Nations that have revolutions, military coups, or fight wars grow more slowly Region: Nations located far from the equator grow more rapidly; nations in SubSahara Africa grow more slowly ECONOMIC GROWTH Policies for Achieving Faster Growth Growth theory and the empirical evidence suggest some policies that might stimulate growth: Stimulate saving, to increase capital accumulation Stimulate research and development, to increase technology Improve the quality of education, to increase human capital Provide international aid to developing nations However studies show that aid tends to get diverted to consumption If the objective is to increase growth, then the aid must be carefully directed Encourage international trade, to increase international specialization Economic Freedom of the World Index: http://www.freetheworld.com/powerpoint.html I like to bring in Economic Freedom to the discussion of this chapter The website link above brings you to power point presentations that refer to the data collected on five categories that make up a single index number that allows the researchers to rank countries according to the amount of economic freedom Students relate very easily to the correlations drawn between economic freedom and important variables like life satisfaction, income, life expectancy, political rights, civil rights, etc The chapter concludes with an Economics in the News analysis of economic growth in South Africa compared to its neighbor, Botswana Botswana’s economic growth is significantly more rapid than that in South Africa because Botswana has well defined and respected property rights One political party in South Africa proposes distributing shares in government owned companies, promoting joint ownership in the agricultural sector, and overhauling the nation’s labor market by increasing workers’ skills 63 64 CHAPTER Additional Problems If in 2008 China’s real GDP is growing at percent a year, its population is growing at percent a year, and these growth rates continue, in what year will China’s real GDP per person be twice what it is in 2008? Underinvesting in the Future For the past half century, South Korea, Hong Kong, Taiwan and Singapore have averaged the highest consistent economic growth rates in the world But in one vital respect these countries may have the worst record of investment in the future since homo sapiens evolved: They have the lowest fertility rates in the world For economic growth, raising children is at least as raising new buildings International Herald Tribune, July 7, 2008 a Explain why the rapid growth rates of these Asian economies might be masking a misallocation of resources that will result in lower income per person in the future b Explain the difficulties in balancing goals for immediate economic growth and future economic growth Solutions to Additional Problems China’s real GDP is growing at percent a year and its population is growing at percent a year, so China’s real GDP per person is growing at percent a year The rule of 70 tells us that China’s real GDP per person will double in 70/8 = 8¾ years So at this rate China’s real GDP per person will be twice what it is in 2008 in 2017 a The new growth theory concludes that population growth increases economic growth because population growth means more people to develop new knowledge and new technologies The Asian economies are currently growing rapidly but their population growth is extremely slow The new growth theory predicts that the slow population growth means that in the future their economic growth rates will slow b People have a limited amount of time, which they can spend at work, perhaps developing new knowledge or new technology, or at home, raising children If they spend their time at work, immediate economic growth will be higher than if they spend the time at home But if they spend their time at home raising children, the future economic growth will be higher as the population growth is higher Additional Discussion Questions 11 What has been the average annual growth in real GDP per person in the United States over the last 100 years? Over the past 50 years, during which periods has annual growth been more rapid than the average? When has it been slower? The average annual growth rate in real GDP per person in the United States has been percent over the past 100 years Growth was most rapid in the 1960s It was also rapid in the 1990s Growth slowed in the 1970s This slowdown is the “productivity growth slowdown.” 12 What is an aggregate production function? A change in what factor or factors cause a movement along the aggregate production function? A change in what factor or factors shifts the aggregate production ECONOMIC GROWTH function? The aggregate production function shows the relationship between real GDP and the quantity of labor employed when all other influences on production remain the same Changes in employment create movements along the aggregate production function Changes in other factors of production, such as capital, as well as changes in technology, shift the aggregate production function 13 Define labor productivity Why is labor productivity important? Labor productivity is equal to real GDP divided by aggregate labor hours, so it tells the quantity of real GDP produced by an hour of labor Labor productivity is important because it is directly related to the standard of living The standard of living is real GDP per person so labor productivity is essentially the “standard of living per worker.” Therefore an increase in labor productivity means there is an increase in the standard of living 14 Explain why reducing uncertainty with respect to property rights is regarded as likely to stimulate economic growth Necessary preconditions for economic growth are physical capital growth, human capital growth, and technological advances However people are willing to invest in physical capital and human capital only if they believe they will be able to reap the rewards from their investment If property rights are unsecure, so that investors are unsure if they will gain from the investment, then people are much less likely to invest in either physical capital or human capital Uncertainty about property rights therefore will dramatically slow economic growth because it will slow growth in physical and human capital The story about technology is similar: People are willing to invest in new technology only if they believe they personally will reap the rewards Once again, reducing uncertainty about property rights will increase people’s incentives to develop new technology, which will lead to more rapid economic growth 15 What role technological advances play in the classical theory of growth? The neoclassical theory? The new theory? In all the growth models a technological advance raises economic growth and real GDP per person But whether the increase is temporary or permanent differ among the models In the classical growth model a technological advance temporarily raises economic growth and real GDP per person After the advance economic growth ceases And the ensuing increase in population drives real GDP per person back to the subsistence level In the neoclassical growth model a technological advance temporarily raises economic growth and permanently raises real GDP per person After the advance economic growth ceases But the increase in the capital stock brought about by the advance allows real GDP per person to remain permanently higher In the new growth theory a technological advance permanently increases economic growth and real GDP per person In the new growth theory a technological advance creates new profit opportunities so that pursuit of profit leads to still more technological advances and investment in capital As a result economic growth persists And with the persistence of economic growth, the increase in real GDP per person is permanent and increasing over time 65 66 CHAPTER ... play in the classical theory of growth? The neoclassical theory? The new theory? In all the growth models a technological advance raises economic growth and real GDP per person But whether the increase... Market The Demand for Labor The demand for labor is the relationship between the quantity of labor demanded and the real wage rate The real wage rate equals the money wage rate divided by the. .. hire more labor only if the real wage falls to reflect the fall in the additional output the labor produces There is a negative relationship between the real wage rate and the quantity of labor
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