Potential GDP & Economic growth Chapter 17

Economic Freedom

A condition in which people are able to make personal choices. their private property is protected by the rule of law, and they are free to buy and sell in markets.

Production function

A relationship that shows the maximum quantity of real GDP that can be produced as the quantity of labor employed changes and all other influences on production remain the same.

Economic Growth

A sustained expansion of production possibilities. Economic growth is different from the rise in incomes that occurs during the recovery from a recession. Economic growth is a sustained trend, not a temporary cyclical expansion.

Discoveries and Choices

Chance does not determine the pace at which new discoveries are made, and at which technology advances. It depends on how many people are looking for a new technology and how intensively they are looking.

Today's Consensus

Each of the earlier schools provides insights and ingredients that survive in today's consensus. Another component of today's consensus is the view that the long-term problems of economic growth is more important than the short-term problem of recessions.

Markets

Economic freedom also requires free markets. Buyers and sellers get information and do business with each other in markets. Property rights and markets create incentives for people to specialize and trade, to save and invest, to expand their human capital, and to discover and apply new technologies.

Create incentive mechanisms

Economic growth occurs when the incentives to save, invest and innovate are strong enough. These incentives require property rights enforced by a well-functioning legal system. Property rights and a legal system are the key ingredients that are missing in many societies.

Encourage research and development

Everyone can use the fruits of basic research and development efforts. Government can direct public funds toward financing basic research, but this solution is not foolproof. 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. The fastest growing nations today are those with the fastest growing exports and imports.

Expansion of Human Capital

Human capital-the accumulated skill and knowledge of people- comes from three sources. 1) Education and training 2) job experience 3) Health and diet Expansion of human capital is the most fundamental source of economic growth because it directly increases labor productivity and is the source of the discovery of new technology.

Law of diminishing marginal returns

If the quantity of capital is small, an increase in capital brings a large increase in production; and if the quantity of capital is large, an increase in capital brings a small increase in production

Potential GDP

Is the value of real GDP when all the economy's factors of production- Labor, Land, Capital, and entrepreneurial ability- are fully employed.

What keeps labor productivity growing?

Labor productivity keeps growing because of the choices people make in the pursuit of profit. The growth theory by Paul Romer emphasizes three facts about market economies: 1) Human capital expansion and choices 2) Discoveries and choices 3) Discoveries and profit

Labor force participation

Most people have productive opportunities outside the labor force and choose to work only if the real wage rate exceeds the value of other productive activities. For example, a parent might spend time caring for her or his child. the alternative is the daycare. The parent will choose to work only if he or she can earn enough per hour to pay the cost of daycare and have enough left to make the work effort worthwhile. The higher the real wage rate, the more likely it is that a parent will choose to work and so the greater is the labor force participation rate.

Human capital expansion and choices

People decide how long to remain in school, what to study, and how hard to study. And when they graduate from school, people make more choices about job training and on-the-job learning. All these choices govern the speed at which human capital expands.

How much difference can policy make?

Political equilibrium arises from the balance of the interests of one group against the interests of another group. Change brings gains for some and losses for others, so change is slow. A well-intentioned government cannot dial up a big increase in the economic growth rate, but it can pursue policies that will nudge the economic growth rate upward. overtime the benefits from these policies will be large.

Discoveries and profits

Profit is the spur to technological change. 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.

Encourage saving

Saving finances investment, which brings capital accumulation. So encouraging saving can increase the growth of capital and stimulate economic growth.

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.

Economic growth rate

The annual percentage change of real GDP Growth rate of real GDP= Real GDP in current year- Real GDP in previous year/Real GDP in previous year X100

Labor market equilibrium

The forces of supply and demand operate in labor market just as they do in the markets of goods and services. The price of labor services is the real wage rate. A rise in the real wage rate eliminates a shortage of labor by decreasing the quantity demanded and increasing the quantity supplied. A fall in the real wage rate eliminates a surplus of labor by increasing the quantity demanded and decreasing the quantity supplied. If there is neither a shortage nor a surplus, the labor market is in equilibrium.

Improve the quality of education

The free market would produce too little education because it brings social benefits beyond the benefits to the people who receive the education. By funding basic education and by ensuring high standard in skills such as language, mathematics, and science, governments can contribute enormously to a nation's growth potential.

Discovery of new technologies

The growth of physical capital and the expansion of human capital have made large contributions to economic growth, but the discovery of new technologies has made an even greater contribution. Since the Industrial Revolution, technological change has become a part of everyday life, Firms routinely conduct research to develop technologies that are more productive.

Quantity of labor supplied

The number of labor hours that all the households in the economy plan to work during a given time period at a given real wage rate.

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

The labor market

The quantity of labor employed depends on firms' decision s about how much labor to hire (the demand for labor). It also depends on households' decisions about how to allocate time between employment and other activities (the supply of labor). And it depends on how the labor market coordinates the decisions of firms and households (labor market equilibrium). 1) the demand for labor 2) the supply of labor 3) Labor market equilibrium.

Labor productivity

The quantity of real GDP produced by one hour of labor. Labor productivity= Real GDP/Aggregate hours When labor productivity grows, real GDP per person grows. So the growth in labor productivity is the basis of the rising standard of living.

Hours per person

The real wage rate is the opportunity cost of taking leisure and not working. As the opportunity cost of taking leisure rises, other things remaining the same, households choose to work more. But other things don't remain the same. A higher real wage rate brings a higher income, which increases the demand for leisure and encourages less work.

The demand for labor

The relationship between the quantity of labor demanded and the real wage rate when all other influences on firm's hiring plans remain the same.

The Supply of Labor

The relationship between the quantity of labor supplied and the real wage rate when all other influences on work plans remain the same.

Productivity curve

The relationship that shows how real GDP per hour of labor changes as the quantity of capital per hour of labor changes.

Property rights

The social arrangements that govern the protection of private property. They include the rights to physical property, to financial property, and to intellectual property. Physical property: land, buildings and capital equipment Financial property: the claims of one person against another Intellectual property: inventions.

Real GDP per person

The standard of living depends on real GDP per person, 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 can use the formula above to calculate real GDP per person real GDP/person= real GDP/population We can also use another formula Growth rate of real GDP/person= Growth rate of real GDP- Growth rate of population

Diminishing returns

The tendency for each additional hour of labor employed to produce a successively smaller additional amount of real GDP Diminishing returns arise because the quantity of capital ( and other factors of production) is fixed. As more labor is hired, the additional output produced decreases because the extra workers have less capital with which to work.

The three main schools of thought

The three main schools of macroeconomic thought are: 1) Classical macroeconomics 2) Keynesian macroeconomics 3) Monetarist macroeconomics

Quantity of labor demanded

The total labor hours that all the firms in the economy plan to hire during a given time period at a given real wage rate.

Keynesian macroeconomics

The view that the market economy is inherently unstable and needs active government intervention to achieve full employment and sustained economic growth.

Classical macroeconomics

The view that the market economy works well, that aggregate fluctuations are a natural consequence of an expanding economy, and that government intervention cannot improve the efficiency of the market economy.

Monetarist macroeconomics

The view that the market economy works well, that aggregate fluctuations are a natural consequence of an expanding economy, but that fluctuations in the quantity of money generate the business cycle.

Why is it important to understand the forces that determine potential GDP?

Three reasons: 1) When the economy is at full employment, real GDP equals potential GDP, so actual real GDP is determined by the same factors that determine potential GDP 2) Real GDP can exceed potential GDP only temporarily as it approaches and then recedes from a business cycle peak. So potential GDP is the sustainable upper limit of production. 3) Real GDP fluctuates around potential GDP, which means that on the average over the business cycle, real GDP equals potential GDP.

Policies to achieve faster growth.

To achieve faster economic growth, we must increase the growth rate of capital per hour of labor, increase the growth rate of human capital, or increase the pace of technological advance. To achieve these objectives, the government can take these main actions. 1) Create incentive mechanisms 2) Encourage savings 3) Encourage research and development 4) encourage international trade 5) Improve the quality of education.

What makes labor productivity grow?

Two broad headings influence the productivity growth: 1) Saving and investment in physical capital 2) Expansion of human capital and discovery of new technologies.

Full employment and potential GDP

When the labor market is in equilibrium, the economy is at full employment and real GDP equals potential GDP

Rule of law

an efficient legal system, and the ability to enforce contracts are essential foundations for creating economic freedom. Impediments to economic freedom are corruption in the courts and government bureaucracy.

Why does the real wage rate influence the quantity of labor?

because what matters to people is not the number of dollars they earn but what those dollars will buy. The quantity of labor supplied increases as the real wage rate increases for two reasons: 1) hours per person increase 2) Labor force participation increases

Saving and investment in physical capital

increase the amount of capital per worker and increase labor productivity.

What does the growth rate of real GDP tell us?

it 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