Macroeconomics: Ch. 9 / Economic Growth and Rising Living Standards

The Rule of 70

tells us that if a variable is growing by X percent per year, it will double in approximately 70/X years

Human Capital and Economic Growth

An increase in human capital works like an increase in physical capital to increase output: it causes the production function to shift upward, and can raise productivity and living standards

The Limits to Growth from More Capital

As capital per worker grows, further increases in capital per worker suffer from diminishing returns, and rising depreciation makes it harder and harder to increase capital per worker out of ongoing investment spending. Thus, increases in the capital stock alone cannot create permanent high rates of economic growth

Increasing the Growth of Labor Demand

all else equal, government policies that help increase the skills of the workforce or that subsidize employment more directly increase labor demand and employment, raising the EPR and real GDP per capita

Productivity Growth: Increases in the Capital Stock

- Capital per Worker: the total capital stock % total employment - the most important determinant of long-run economic growth, and the one that economists and policy makers focus on, is rising productivity - all else equal, a rise in Capital per Worker (the total capital stock % total employment) causes labor productivity to rise

What Makes Economies Grow?

- Real GDP per capita is a fraction - in order for this fraction to grow, the numerator (real GDP) must grow faster than the denominator (population)

The Growth Equation

- an equation showing the percentage growth rate of real GDP per capita as the sum of the growth rates of productivity, average hours, and the employment-population ratio % Change Real GDP per Capita ~ % Change Productivity + % Change Average Hours + % Change EPR

Average Hours

- average number of hours a worker spends on the job can be found by dividing the total hours worked by everyone by total employment (the number of people who worked during the period) Average Hours = Total Hours % Total Employment

The Employment-Population Ratio (EPR)

- fraction of the population that is working EPR = Total Employment % Population

Government and Catch-Up Growth

- institutions that government helps to create and manage can bring about catch-up growth - ex: China's switch to system of well-defined property rights, encouraging competition in the marketplace, rooting out corrupt bureaucrats, investing in education, specializing in goods and services it is well-suited to produce and export, etc

Changes in Labor Supply and Labor Demand

- one cause of a rise in total employment is an increase in labor supply -- if more people want to work at any wage, market-clearing wage begins to drop -- business firms, finding labor cheaper, hire more workers, moving the market from point A to point B -- rise in total employment would increase the EPR, and the rise in total output would increase real GDP per capita - greater employment can also arise from an increase in labor demand -- wage rate begins to rise, more people decide to work, market-clearing wage rises, equilibrium employment rises - labor supply increases, wage rate falls - labor demand increases, wage rate rises

Investment and Capital Stock

- the rate of planned investment spending in the economy determines how fast the capital stock rises - capital = stock variable / the total amount of plant and equipment that exists in the economy - investment spending = flow variable / the amount of new capital being installed over some time interval - depreciation = flow variable / tends to reduce capital stock over time, greater flow of investment spending means faster rise in capital stock for a given rate of depreciation and total employment, a higher rate of investment spending causes faster growth in capital per worker, faster growth in productivity, and faster growth in the average standard of living

Growth in the Employment Population Ratio (EPR)

- with a given population, greater total employment means an increase in the EPR, and a rise in real GDP per capita

Determinants of Real GDP

1. the amount of output the average worker produces in an hour 2. the number of hours the average worker spends at the job 3. the fraction of the population that is working 4. the size of the population

Summary

Average Standard of Living measured by Real GDP per Capita - if output grows faster than population, then real GDP per capita rises - in order for output per person to rise, average working hours, the employment-population ratio (EPR), or labor productivity must increase Growth in EPR - can be increased by policy changes that increase labor supply or labor demand - increases in EPR can't continue forever and are unlikely to be a significant source of growth in the future - this leaves increases in productivity, a major contributor to growth in the past, as the main source of growth in the future One determinant of productivity is Capital per Worker - capital stock will rise when the flow of investment spending is greater than the flow of depreciation over some period of time - an increase in the capital stock shifts the production function upward, enabling any given number of workers to produce more output - if capital stock rises at a faster rate than employment, then capital per worker rises, and so goes productivity - government policies can increase investment directly, by providing subsidies and incentives for business firms to invest - government can also increase investment indirectly, through policies that lower interest rates, such as changes in tax policy to encourage more private saving or reductions in the government's budget deficit Another determinant of productivity is Technological Change - the discovery of new ways of combining inputs, including the creation of new types of capital - in rich countries, technological change from new discoveries is the main driver of economic growth - in poor countries, technological change is a major factor behind catch-up growth, because they can rapidly adopt discoveries already made through richer countries - rate of technological change in rich countries depends partly on spending on R&D, either by government or private firms - almost any government policy that increases investment spending in general will also increase spending on R&D, and therefore increase the pace of technological change - a country's institutions (such as its laws, regulations, and political system) are important in determining the pace of new discoveries Cost of Economic Growth - tax cuts that stimulate employment, capital formation, or technological progress require increases in other taxes, cuts in government spending, or an increase in the deficit that adds to the nation's total debt - producing more capital or funding more R&D activities requires the sacrifice of current consumption - growth often involved some tradeoff with other social goals, such as a clean environment or social stability

The Meaning and Importance of Economic Growth

Economic Growth = rise in the Standard of Living

Discovery-Based Growth

Economic growth, primarily in advanced countries, based on technological change from new discoveries In rich countries, sustained growth in productivity and living standards arises from discovery-based growth. Without a continual supply of new ideas, growth in rich-country living standards would soon slow and ultimately come to a halt There are no logical or mathematical limits to productivity growth from new discoveries. New ideas are not subject to diminishing returns, nor do they depreciate over time

Catch-Up Growth

Economic growth, primarily in less-advanced countries, based on increasing capital per worker from low levels, and adopting technologies already used in more advanced countries In poor countries, sustained growth in productivity and living standards is largely catch-up growth. They start with very low capital per worker, so catching up to the higher levels of rich countries yields large productivity gains. And technological change can occur rapidly, by copying and adapting technologies already in use in richer countries

Growth Policies: A Summary

Fiscal Policy and Economic Growth - Supply-side effects: macroeconomic policy effects on total output that work by changing the quantities of resources available - in the long run, fiscal policy cannot change total output through a change in total spending (demand-side effects). But it can change the total output by altering the quantity of resources available for production (supply-side effects) The Costs of Economic Growth - promoting economic growth involves unavoidable tradeoffs: it requires some groups, or the nation as a whole, to give up something else that is valued Budgetary Costs - even though properly targeted tax cuts can increase the rate of economic growth, they will generally force us to either redistribute the tax burden or cut government programs Consumption Costs - greater investment in physical capital, human capital, and R&D will lead to faster economic growth and higher living standards in the future, but we will have fewer consumer goods to enjoy in the present Sacrifice of Other Social Goods - achieving social goals often requires the sacrifice of some economic growth along the way. Alternatively, achieving faster economic growth may require some compromise on other things we care about

The Limits to the EPR as a Growth Strategy

Government policy can raise the EPR and so create economic growth temporarily (while the EPR is rising). but significant, sustained economic growth would require significant, sustained growth in the EPR, which is not realistic

Productivity

Labor Productivity: the output produced by the average worker in an hour Productivity = output per hour = Total Output % Total Hours Worked

Barriers to Catch-Up Growth in the Poorest Countries

Problems: 1. Extremely low output per capita 2. High population growth rates 3. Poor institutions The poorest countries are too poor to increase living standards by exploiting the normal tradeoff between consumption and capital production. If they cannot reduce consumption below current levels, they cannot raise capital production enough to increase productivity over time. Historical Attempts at Breaking Poverty Cycle: 1. Brute force 2. Targeting the wealthy 3. Decreasing population growth 4. Foreign assistance

Real GDP

Productivity x Average Hours x EPR x Population

Government and Discovery-Based Growth

Research and Development Spending - require firms to spend now for the uncertain prospect of profits in the future - funds for projects drawn from the loanable funds market - increase in Gov's R&D spending can, like private spending, increase the pace of technological change Institutional Infrastructure and Innovation - Gov provides institutional infrastructure that encourages innovation - laws to protect property rights, honest gov agencies to enforce the law, and impartial judicial system to settle disputes

Measuring Living Standards

Standard of Living = level of economic well-being its economy delivers to its citizens - measured by real domestic product per capita, or real GDP divided by the population -- Problems: --- GDP doesn't measure leisure time, workplace safety, good health, a clean environment, etc... --- does not take account of how goods and services are distributed within the country

How to Increase Investment

Targeting Businesses: Increasing the Incentive to Invest - reducing business taxes or providing specific investment incentives can shift the investment curve rightward, thereby creating faster growth in physical capital. This leads to faster growth in productivity and output per capita. -- Corporate Profits Tax: tax on the profits earned by corporations -- Investment Tax Credit: a reduction in taxes for firms that invest in new capital Targeting Households: Increasing the Incentive to Save - Government can alter the tax and transfer system to increase incentives for saving. This would make more funds available for investment, speed growth in capital stock, and speed the rise in living standards. -- Capital Gains Tax: tax on profits earned when a financial asset is sold at more than its acquisition price -- Consumption Tax: tax on the part of their income that households spend Shrinking the Budget Deficit - All else equal, a decrease in the budget deficit tends to reduce interest rates and increase investment, thus speeding the growth in the capital stock - Government investment in new capital and the maintenance of existing capital make important contributions to economic growth - the impact of deficit reduction on economic growth depends on which government programs are cut. Shrinking the deficit by cutting government investment will not stimulate growth as much as would cutting other types of government spending

Capital Growth VS Technological Change

The faster the rate of technological change, the greater the growth rate of productivity, and the faster the rise in living standards

Productivity Growth: Technological Change

The invention and use of new inputs, new outputs, or new production methods

Increasing the Growth of Labor Supply

a cut in tax rates increases the reward for working, while a cut in certain benefit programs increases the hardship of not working. All else equal, either policy can increase labor supply and employment, raising the EPR and real GDP per capita