Macro 3- Economic growth

Neoclassical growth theory

.Argues real GDP per person grows due to technological progress that raises labour productivity. .As long as there is some technological progress GDP per person will grow (assumption) .However, if tech progress stops so will growth of GDP per person due to diminishing returns. .Under this view, gains in real GDP per person are permanent and do not depend on population growth .Overcomes main problem of classical theory as tech progress. .However, it does not explain HOW tech progress comes around which is key to policies for growth .In addition, it cannot explain why some countries are poor/rich as technology and knowledge should move across borders. >New growth theory tries to explain this

Growth theories

1.Classical growth theory 2.Neoclassical growth theory 3.New growth theory In historical order as theory builds upon the insights of the previous one

Why does Real GDP increase

1.Economy is in the expansion phase of the business cycle 2.Potential GDP is increasing Expansion phase of the business cycle is not economic growth, but rising GDP due to an increase in potential output is

Economic growth equation/ growth rate

Growth rate=real GDP in current year-Real GDP in prev year divided by Real GDP in prev year x 100

Economic growth

is a sustained expansion of production possibilities measured as the increase in real GDP over a given time period.

What makes potential GDP grow?

2 main factors: 1.Growth of supply of labour 2.Growth of labour productivity When supply of labour grows, the supply of labour curve shifts to the right, lowering real wage rate and increasing hours of labour employed When labour productivity increases, output per hour of labour employed grows, shifting the production function upwards and the demand of labour to the right.

New growth theory

>Argues that real GDP per person grows indefinitely - with the rate of growth being linked to the scale and intensity of the search for new tech. >Incentives drive the search for new tech >Increased profit=award for new tech, this can fund R&D >Property rights and the rule of law have an important role in making the look for new tech attractive (e.g. patents) >New growth theory holds that increasing the stock of knowledge makes existing capital and labour more productive >Also argues: -Discoveries are a public capital good -Knowledge is not subject to diminishing returns

New growth theory pt 2

>Discoveries are a public good as one persons use does not prevent others from using it and no one can be excluded from using it >Knowledge is not subject to diminishing returns because future discoveries are built on the current stock of knowledge >New growth views economy as a PERPETUAL MOTION MACHINE: -Innovation- leads to development of better techniques and products -Productivity- increases and so wages rise, enabling us to consume more and take more leisure -Further innovations- are made to profit from the demand for extra consumption and labour saving devices >Because discoveries are a public good the whole economy benefits >Because knowledge is not subject to diminishing returns, the return to innovation and investment in education is extremely high

Growth rate of Real GDP per person

Measures increases in standards of living Can be done in ways: 1.Replace real GDP with real GDP per person in the growth rate formula 2.Real GDP growth rate-population growth rate

Potential GDP and economic growth

Potential GDP-is the quantity of GDP produced when the quantity of labour employed is the full employment quantity We focus on quantity of labour employed as this is the only variable FOP To determine potential GDP we use a model with 2 components- an aggregate production function, an aggregate labour market

Classical growth theory

States that growth in real GDP per person is temporary because it leads to population explosion that will eventually bring real GDP per person back to its original level. View associated with Rev Thomas Malthus, who had a 'doomsday' view that population growth would outstrip our ability to produce goods/services including food. Modern day Malthusians believe this may occur if world pop excludes 11billion by 2050 and if serious action is not taken to counter act global warming and climate change. Contrary to prior predictions of classical theory, historical evidence is that pop growth is not tightly linked to GDP per person and does not reverse improvements in standards of living Main prob with this theory is that it presumes labour productivity is static. In practice labour productivity is growing over time so pop growth does not imply dwindling resources per person. This assumption of static productivity is relaxed in neoclassical growth theory.

The aggregate production function

Tells us how real GDP changes as the quantity of labour changes when all other influences on production remain the same. An increase in aggregate labour increases REAL GDP We can show this movement along the aggregate production function Increasing labour supply increases Real GDP at a decreasing rate due to the law of diminishing returns

The aggregate labour market

The demand for labour shows the relationship between quantity of labour demand and the real wage rate. .The REAL WAGE RATE is money wage rate divided by price level .Supply of labour shows us the relationship between quantity of labour supplied and real wage rate Labour market is in equilibrium at the real wage rate at which the labour demand equals labour supplied

How potential GDP is determined

The economy is at FULL EMPLOYMENT when 50 billion hours of labour are employed and the real wage is 20 per hour. Potential GDP is the amount of GDP that can be produced with 50 billion hours of labour. From the production function we can see that potential GDP is equal to £1.5trillion

The rule of 70

The number of years it takes for the level of a variable to double is approximately 70 divided by the annual percentage growth rate of that variable. e.g. Years for level to double= 70 divide by growth rate