chapter 6 economic vocab

what is 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 the variable.

The quantity of labor demanded increases

as the real wage rate decreases—the demand for labor curve slopes downward.

To reap the benefits of technological change,

capital must increase. Some of the most powerful and far-reaching fundamental technologies are embodied in human capital—for example, language, writing, and mathematics. But most technologies are embodied in physical capital. For example, to reap the benefits of the internal combustion engine, millions of horse-drawn carriages had to be replaced with automobiles; and to reap the benefits of digital music, millions of Discmans had to be replaced by smartphones.

But the population increase

decreases potential GDP per hour of labor.

Labor productivity grows

indefinitely as people discover new technologies that yield a higher real interest rate. The growth rate depends only on people's incentives and ability to innovate.

New growth theory emphasizes the capacity of human resources to

innovate at a pace that offsets diminishing returns. New growth theory fits the facts of today's world more closely than do either of the other two theories.

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.

The real wage rate influences the quantity of labor supplied because what matters to households

is not the number of dollars they earn (money wage rate) but what they can buy with those dollars.

But a one-shot rise in real GDP or a recovery from recession

isn't economic growth.

The return to full employment in an expansion phase of the business cycle

isn't economic growth. It is just taking up the slack that resulted from the previous recession. Howvever, The expansion of potential GDP is economic growth.

As the amount of capital per worker increases,

labor productivity also increases.

The implication of this simple and appealing observation is astonishing. Unlike the other two theories, new growth theory has

no growth-stopping mechanism. As physical capital accumulates, the return to capital—the real interest rate—falls. But the incentive to innovate and earn a higher profit becomes stronger. So innovation occurs, capital becomes more productive, the demand for capital increases, and the real interest rate rises again.

Knowledge is even more special because it is

not subject to diminishing returns. But increasing the stock of knowledge makes both labor and machines more productive. Knowledge capital does not bring diminishing returns. Biotech knowledge illustrates this idea well. Biologists have spent a lot of time developing DNA sequencing technology. As more has been discovered, the productivity of this knowledge capital has relentlessly increased. In 1990, it cost about $50 to sequence one DNA base pair. That cost had fallen to $1 by 2000 and to 1/10,000th of a penny by 2010.

Classical growth theory reminds us that

our physical resources are limited and that without advances in technology, we must eventually hit diminishing returns.

No matter how rich we become,

our wants exceed our ability to satisfy them. We always want a higher standard of living. In the pursuit of a higher standard of living, human societies have developed incentive systems—markets, property rights, and money—that enable people to profit from innovation. Innovation leads to the development of new and better techniques of production and new and better products. To take advantage of new techniques and to produce new products, new firms start up and old firms go out of business—firms are born and die. As old firms die and new firms are born, some jobs are destroyed and others are created. The new jobs created are better than the old ones and they pay higher real wage rates. Also, with higher wage rates and more productive techniques, leisure increases. New and better jobs and new and better products lead to more consumption goods and services and, combined with increased leisure, bring a higher standard of living.

New growth theory sees the economy as a

perpetual motion machine, which Fig. 6.12 illustrates.

If labor productivity increases,

production possibilities expand. The quantity of real GDP that any given quantity of labor can produce increases.

Tax incentives can increase saving. Individual Retirement Accounts (IRAs) are a tax incentive to save. Economists claim that a tax on consumption rather than income

provides the best saving incentive.

Economic growth occurs when

real GDP increases.

It seems obvious that if rich countries give financial aid to developing countries

, investment and growth will increase in the recipient countries. Unfortunately, the obvious does not routinely happen. A large amount of data-driven research on the effects of aid on growth has turned up a zero and even negative effect. Aid often gets diverted and spent on consumption.

What does the real GDP growth rate tell us?

-The growth rate of real GDP tells us how rapidly the total economy is expanding. This measure is useful for telling us about potential changes in the balance of economic power among nations. But it does NOT tell us about changes in the standard of living.

the quantity of labor changes as a result of changes in

1. Average hours per worker 2. The employment-to-population ratio 3. The working-age population

What Makes Potential GDP Grow? We can divide all the forces that make potential GDP grow into two categories:

1. Growth of the supply of labor 2. Growth of labor productivity

Everyone can use the fruits of basic research and development efforts. For example, all biotechnology firms can use advances in gene-splicing technology. Because basic inventions can be copied, the inventor's profit is limited and the market allocates too few resources to this activity.

Governments can direct public funds toward financing basic research, but this solution is not foolproof. It requires a mechanism for allocating the public funds to their highest-valued use.

How to calculate labor productivity?

It is calculated by dividing real GDP by aggregate labor hours. For example, if real GDP is $18 trillion and aggregate hours are 200 billion, labor productivity is $90 per hour.

What is economic growth?

It is the expansion of production possibilities.

So an increase in labor productivity increases potential GDP for two reasons:

Labor is more productive and more labor is employed.

What Determines Potential GDP?

Labor, capital, land, and entrepreneurship produce real GDP, and the productivity of the factors of production determines the quantity of real GDP that can be produced.

But our insatiable wants are still there, so the process continues:

Wants and incentives create innovation, new and better products, and a yet higher standard of living.

An increase in the quantity of labor (and a corresponding decrease in leisure hours) brings

a movement along the production function and an increase in real GDP.

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 rate of real GDP, then real GDP per person falls.

So an increase in the population

increases the full-employment quantity of labor, increases potential GDP, and lowers the real wage rate.

An increase in the population

increases the supply of labor. I

The real wage rate influences the quantity of labor demanded because what matters to firms

is not the number of dollars they pay (money wage rate) but how much output they must sell to earn those dollars.

In macroeconomics, we pretend

that there is one large labor market that determines the quantity of labor employed and the quantity of real GDP produced. To see how this aggregate labor market works, we study the demand for labor, the supply of labor, and labor market equilibrium.

In neoclassical growth theory,

the pace of technological change influences the economic growth rate but economic growth does not influence the pace of technological change.

Profit is the

spur to technological change.

How do we express the growth rate?

As the annual percentage change of a variable—the change in the level expressed as a percentage of the initial level.

Two facts about discoveries and technological knowledge play a key role in the new growth theory:

Discoveries are (at least eventually) a public capital good; and knowledge is capital that is not subject to diminishing marginal returns.

The contrast between the Malthusian theory and new growth theory couldn't be more sharp.

Malthusians see the end of prosperity as we know it today and new growth theorists see unending plenty. The contrast becomes clearest by thinking about the differing views about population growth.To a Malthusian, population growth is part of the problem. To a new growth theorist, population growth is part of the solution. People are the ultimate economic resource. A larger population brings forth more wants, but it also brings a greater amount of scientific discovery and technological advance. So rather than being the source of falling real GDP per person, population growth generates faster labor productivity growth and rising real GDP per person. Resources are limited, but the human imagination and ability to increase productivity are unlimited.

The growth rate of real GDP, for example, is calculated as:

Real GDP growth rate=Real GDP in current year−Real GDP in previous year Real GDP in previous year×100.

The main suggestions for achieving these objectives are

Stimulate saving, Stimulate research and development, Improve the quality of education, Provide international aid to developing nations, Encourage international trade

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 quantity of land is fixed and on any given day, the quantities of entrepreneurial ability and capital are also fixed and their productivities are given. What is the one variable factor of production

The quantity of labor employed is the only variable factor of production.

Many people today are Malthusians. What do they say?

They say that if today's global population of 7.2 billion explodes to 11 billion by 2050 and perhaps 35 billion by 2300, we will run out of resources, real GDP per person will decline, and we will return to a primitive standard of living. We must, say Malthusians, contain population growth.Modern-day Malthusians also point to global warming and climate change as reasons to believe that, eventually, real GDP per person will decrease.

Neoclassical growth theory reaches the same conclusion but not because of a population explosion. Instead, it emphasizes

diminishing returns to capital and reminds us that we cannot keep growth going just by accumulating physical capital. We must also advance technology and accumulate human capital. We must become more creative in our use of scarce resources.

Trade, not aid, stimulates economic growth. It works by

extracting the available gains from specialization and trade. The fastest-growing nations are those most open to trade. If the rich nations truly want to aid economic development, they will lower their trade barriers against developing nations, especially in farm products. The World Trade Organization's efforts to achieve more open trade are being resisted by the richer nations.

If labor is more productive,

firms are willing to pay more for a given number of hours of labor so the demand for labor also increases.

You've seen that along the production function, each additional hour of labor increases real GDP by successively smaller amounts. This tendency has a name: the law of diminishing returns. Because of diminishing returns,

firms will hire more labor only if the real wage rate falls to match the fall in the extra output produced by that labor.

But labor hours are not all equally productive. We use our most productive hours first, and as more hours are worked, these hours are increasingly less productive. Therefore ...

for each additional hour of leisure forgone (each additional hour of labor), real GDP increases but by successively smaller amounts.

Because knowledge is a public good, as the benefits of a new discovery spread,

free resources become available. Nothing is given up when they are used: They have a zero opportunity cost. When a student in Austin writes a new iPhone app, his use of the programming language doesn't prevent another student in Seattle from using it.

Human capital—the accumulated skill and knowledge of human beings—is the

fundamental source of labor productivity growth. Human capital grows when a new discovery is made and it grows as more and more people learn how to use past discoveries.

The free market produces too little education because it brings benefits beyond those valued by the people who receive the education. By funding basic education and by ensuring high standards in basic skills such as language, mathematics, and science,

governments can contribute to a nation's growth potential. Education can also be stimulated and improved by using tax incentives to encourage improved private provision.

Population growth brings

growth in the supply of labor, but it does not change the demand for labor or the production function. The economy can produce more output by using more labor, but there is no change in the quantity of real GDP that a given quantity of labor can produce.

But technological change—the discovery and the application of new technologies—

has made an even greater contribution.

An increase in the population increases

he supply of labor and the supply of labor curve shifts rightward.

The standard of living depends on

real GDP per person (also called per capita real GDP), which is real GDP divided by the population. So the contribution of real GDP growth to the change in the standard of living depends on the growth rate of real GDP per person. We use the above formula to calculate this growth rate, replacing real GDP with real GDP per person.

When labor productivity grows,

real GDP per person grows and brings a rising standard of living. Let's see how an increase in labor productivity changes potential GDP.

New growth theory holds that

real GDP per person grows because of the choices people make in the pursuit of profit and that growth will persist indefinitely. Paul Romer of Stanford University developed this theory during the 1980s, based on ideas of Joseph Schumpeter during the 1930s and 1940s.

Neoclassical growth theory is the proposition that

real GDP per person grows because technological change induces saving and investment that make capital per hour of labor grow. Growth ends if technological change stops because of diminishing marginal returns to both labor and capital. Robert Solow of MIT suggested the most popular version of this growth theory in the 1950s.

Saving finances investment so

stimulating saving increases economic growth. The East Asian economies have the highest growth rates and the highest saving rates. Some African economies have the lowest growth rates and the lowest saving rates.

The growth rate of real GDP per person can also be calculated (approximately) by

subtracting the population growth rate from the real GDP growth rate.

Economic growth is a

sustained, year-after-year increase in potential GDP.

Neoclassical growth theory assumes that

technological change results from chance. When we're lucky, we have rapid technological change, and when bad luck strikes, the pace of technological advance slows.

To determine potential GDP, we use a model with two components:

the first is an aggregate production function, and the second is an aggregate labor market

The more leisure we forgo,

the greater is the quantity of labor we supply and the greater is the quantity of real GDP produced.

Classical growth theory is the view that

the growth of real GDP per person is temporary and that when it rises above the subsistence level, a population explosion eventually brings it back to the subsistence level. Adam Smith, Thomas Robert Malthus, and David Ricardo—the leading economists of the late eighteenth and early nineteenth centuries—proposed this theory, but the view is most closely associated with the name of Malthus and is sometimes called the Malthusian theory. Charles Darwin's ideas about evolution by natural selection were inspired by the insights of Malthus.

Neoclassical growth theory says that the prosperity will last but

the growth will not last unless technology keeps advancing.

The fundamental precondition for labor productivity growth is

the incentive system created by firms, markets, property rights, and money. These four social institutions are the same as those described in Chapter 2 (see here) that enable people to gain by specializing and trading.

When there is neither a shortage nor a surplus,

the labor market is in equilibrium—a full-employment equilibrium.

The real wage rate is

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. It contrasts with the money wage rate, which is the number of dollars that an hour of labor earns.

The quantity of labor demanded is

the number of labor hours hired by all the firms in the economy during a given period. This quantity depends on the price of labor, which is the real wage rate.

The quantity of labor supplied is

the number of labor hours that all the households in the economy plan to work during a given period. This quantity depends on the real wage rate.

The quantity of labor is

the number of workers employed multiplied by average hours per worker. The number employed equals the employment-to-population ratio multiplied by the working-age population, divided by 100 (see Chapter 5, here).

According to the new growth theory,

the pace at which new discoveries are made—and at which technology advances—is not determined by chance. It depends on how many people are looking for a new technology and how intensively they are looking. The search for new technologies is driven by incentives.

According to neoclassical growth theory,

the prosperity will persist because there is no classical population growth to induce the wage rate to fall. So the gains in income per person are permanent. But growth will eventually stop if technology stops advancing because of diminishing marginal returns to capital. The high profit rates that result from technological change bring increased saving and capital accumulation. But as more capital is accumulated, more and more projects are undertaken that have lower rates of return—diminishing marginal returns. As the return on capital falls, the incentive to keep investing weakens. With weaker incentives to save and invest, saving decreases and the rate of capital accumulation slows. Eventually, the pace of capital accumulation slows so that it is only keeping up with population growth. Capital per worker remains constant.

Potential GDP is the level of real GDP when

the quantity of labor employed is the full-employment quantity.

Labor productivity is

the quantity of real GDP produced by an hour of labor.

If there is a surplus of labor,

the real wage rate eventually falls to eliminate it.

With an increase in the supply of labor and no change in the demand for labor,

the real wage rate falls and the equilibrium quantity of labor increases. The increased quantity of labor produces more output and potential GDP increases.

The quantity of labor supplied increases as

the real wage rate increases—the supply of labor curve slopes upward. At a higher real wage rate, more people choose to work and more people choose to work longer hours if they can earn more per hour.

With an increase in the demand for labor and no change in the supply of labor,

the real wage rate rises and the quantity of labor supplied increases. The equilibrium quantity of labor also increases.

If there is a shortage of labor,

the real wage rate rises to eliminate it;

The price of labor is

the real wage rate. The forces of supply and demand operate in labor markets just as they do in the markets for goods and services to eliminate a shortage or a surplus. But a shortage or a surplus of labor brings only a gradual change in the real wage rate.

The demand for labor is

the relationship between the quantity of labor demanded and the real wage rate.

The supply of labor is

the relationship between the quantity of labor supplied and the real wage rate.

The aggregate production function is

the relationship that tells us how real GDP changes as the quantity of labor changes when all other influences on production remain the same..

When the supply of labor grows,

the supply of labor curve shifts rightward. The quantity of labor at a given real wage rate increases.

Growth theory supported by empirical evidence tells us that

to achieve faster economic growth, we must increase the growth rate of physical capital, the pace of technological advance, or the growth rate of human capital and openness to international trade.