Macro 6

Real GDP can increase for two distinct reasons:

The economy might be returning to full employment in an expansion phase of the business cycle. Potential GDP might be increasing.

How Potential GDP Grows

The increase in aggregate hours increases potential GDP. Because of the diminishing returns, the increased population ... increases real GDP, but decreases real GDP per hour of labor.

The Neoclassical Theory of Population Growth

The neoclassical view is that the population growth rate is independent of real GDP and the real GDP growth rate.

The economic growth rate

is the annual percentage change of real GDP. The economic growth rate tells us how rapidly the total economy is expanding.

Neoclassical growth theory

is the proposition that real GDP per person grows because technological change induces a level of saving and investment that makes capital per hour of labor grow. Growth ends only if technological change stops because of diminishing marginal returns to both labor and capital.

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 real GDP per person back to the subsistence level.

Growth in the Supply of Labor

Aggregate hours, the total number of hours worked by all the people employed, change as a result of changes in: 1. Average hours per worker 2. Employment-to-population ratio 3. The working-age population growth Population growth increases aggregate hours and real GDP, but to increase real GDP per person, labor must become more productive.

The Effects of Population Growth

An increase in population increases the supply of labor. With no change in the demand for labor, the equilibrium real wage rate falls and the aggregate hours increase. The increase in the aggregate hours increases potential GDP.

Stimulate Research and Development

Because the fruits of basic research and development efforts can be used by everyone, not all the benefit of a discovery falls to the initial discoverer. So the market might allocate too few resources to research and development. Government subsidies and direct funding might stimulate basic research and development.

Encourage International Trade

Free international trade stimulates growth by extracting all the available gains from specialization and trade. The fastest growing nations are the ones with the fastest growing exports and imports.

Policies for Achieving Faster Growth

Growth accounting tells us that to achieve faster economic growth we must either increase the growth rate of capital per hour of labor or increase the pace of technological change. The main suggestions for achieving these objectives are: Stimulate Saving Saving finances investment. So higher saving rates might increase physical capital growth. Tax incentives might be provided to boost saving.

Human Capital Growth

Human capital acquired through education, on-the-job training, and learning-by-doing is the most fundamental source of labor productivity growth.

Provide International Aid to Developing Nations

If rich countries give financial aid to developing countries, investment and growth will increase. But data on the effect of aid shows that it has had zero or a negative effect.

How Potential GDP Grows

In the labor market: An increase in labor productivity increases the demand for labor. With no change in the supply of labor, the real wage rate rises and aggregate hours increase.

Technological Change and Diminishing Returns

In the neoclassical theory, the rate of technological change influences the economic growth rate but economic growth does not influence the pace of technological change. It is assumed that technological change results from chance.

Growth of Labor Productivity

Labor productivity is the quantity of real GDP produced by an hour of labor. Labor productivity equals real GDP divided by aggregate labor hours. If labor becomes more productive, firms are willing to pay more for a given number of hours so the demand for labor increases.

Technological Advances

Technological change—the discovery and the application of new technologies and new goods—has contributed immensely to increasing labor productivity.

Growth Theories, Evidence, and Policies

Technology begins to advance at a more rapid pace. New profit opportunities arise and investment and saving increase. As technology advances and the capital stock grows, real GDP per person increases. Diminishing returns to capital lower the real interest rate and eventually economic growth slows and just keeps up with population growth. Capital per worker remains constant.

Physical Capital Growth

The accumulation of new capital increases capital per worker and increases labor productivity.

Improve the Quality of Education

The benefits from education spread beyond the person being educated, so there is a tendency to under invest in education.

Aggregate Labor Market

The demand for labor shows the quantity of labor demanded and the real wage rate. The real wage rate is the money wage rate divided by the price level. The supply of labor shows the quantity of labor supplied and the real wage rate. The labor market is in equilibrium at the real wage rate at which the quantity of labor demanded equals the quantity of labor supplied.

Potential GDP

The quantity of real GDP produced when the economy is at full employment is potential GDP.

Real GDP per person

The standard of living depends on real GDP per person. is real GDP divided by the population. Real GDP per person grows only if real GDP grows faster than the population grows.

New growth theory

holds that real GDP per person grows because of choices that people make in the pursuit of profit and that growth can persist indefinitely. The theory begins with two facts about market economies: Discoveries result from choices. Discoveries bring profit and competition destroys profit.

The Rule of 70

states that 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 aggregate production function

tells us how real GDP changes as the quantity of labor changes when all other influences on production remain the same. An increase in labor increases real GDP.