Transcript Chapter 23: Why Do Economies Grow?

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Why Do Economies Grow?
Prepared by:
Fernando Quijano and Yvonn Quijano
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Why Do Economies Grow?
• There are two basic mechanisms which
increase GDP per capita over the long term:
• Capital deepening: an increase in the
economy’s stock of capital—plant and
equipment—relative to its workforce.
• Technological progress: the ability to
produce more output without using any
more inputs—capital or labor.
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Measuring Economic Growth
• A meaningful measure of the standard of living
in a given country is real GDP per capita, or
real GDP per person.
• The growth rate of a variable is the
percentage change in that variable from one
period to another.
GDP in year 2  GDP in year 1
%GDP 
x100%
GDP in year 1
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Measuring Economic Growth
• If the economy started at 100 and grew at a
rate g for n years, then real GDP after n years
equals:
GDPn YEARS LATER  (1  g) n (100)
• At 4% for the next ten years, GDP will be:
GDP 10 YEARS LATER  (1  0.04)10 (100) = 148
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Measuring Economic Growth
• To find out how many years it would take for
GDP to double, we use the rule of 70: If an
economy grows at x percent per year, output
will double in 70/x years.
70
Years to double 
( percentage growth rate)
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Measuring Economic Growth
• Making comparisons of real GDP across
countries is difficult. Each country has its own
currency and its own price system.
• Converting the GDP into a common currency
using current exchange rates (the rate at
which one currency trades for another) is the
simplest way to compare GDPs across
countries.
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GNP per Capita and Economic Growth
GNP per
Capita in
Country
1999 Dollars
United States
$31,910
Japan
25,170
France
23,020
United Kingdom
22,200
Italy
22,000
Mexico
8,070
Costa Rica
7,880
Zimbabwe
2,610
India
2,230
Pakistan
1,860
Zambia
720
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Average per Capita
Growth Rate,
1960-1999 (%)
2.13
4.43
2.76
2.07
3.00
2.36
2.23
1.28
1.98
1.04
-1.31
• Japan’s GDP per
capita grew at
4.43% per year,
compared to
2.13% for the
United States.
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GNP per Capita and Economic Growth
GNP per
Capita in
Country
1999 Dollars
United States
$31,910
Japan
25,170
France
23,020
United Kingdom
22,200
Italy
22,000
Mexico
8,070
Costa Rica
7,880
Zimbabwe
2,610
India
2,230
Pakistan
1,860
Zambia
720
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Average per Capita
Growth Rate,
1960-1999 (%)
2.13
4.43
2.76
2.07
3.00
2.36
2.23
1.28
1.98
1.04
-1.31
• Japan’s per
capita output
was doubling
every 16 years
(recall the rule of
70) making this
an extraordinary
rate of growth.
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Growth Rates and Patterns of Growth
• Economists question whether poorer countries
can close the gap between their level of GDP
per capita and that of richer countries.
• The process by which poorer countries catch
up with richer countries in terms of real GDP
per capita is called convergence.
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Countries with Lower Income
in 1870 Grew Faster
• The relationship
between growth rates
and per capita income
in 1870 is downwardsloping.
• Countries with higher
levels of GDP in 1870
grew more slowly than
countries with lower
levels of GDP.
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Increase in the Supply of Capital
• Capital deepening
refers to increases in
the amount of capital
per worker.
• An increase in capital
means more output
can be produced.
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Increase in the Supply of Capital
• Firms will increase
their demand for
labor and, as they
compete for a fixed
labor supply, real
wages will rise.
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Capital Deepening
• Increases in the stock of capital raise real
wages and lead to increases in output.
• How does an economy increase its stock of
capital?
• The economy must increase its net
investment.
• To increase net investment, gross
investment must also rise.
• The amount of income available for
investment comes from saving.
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Saving and Investment
• Total income minus consumption is saving.
• By definition, consumption plus saving equals
income:
C+S=Y
• At the same time, income—which is equivalent
to output—also equals consumption plus
investment:
C+I=Y
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Saving and Investment
• Thus, saving must equal investment:
S=I
• This means, whatever consumers decide to
save goes directly into investment.
• The stock of capital increases with any gross
investment spending but decreases with any
depreciation.
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Saving and Investment
• It follows that in order for the stock of capital to
increase, gross investment must exceed
depreciation.
• However, as capital grows, depreciation also
grows, eventually catching up to the level of
gross investment, and putting a stop to the
growth of capital deepening.
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Population, Growth,
Government, and Trade
• Population growth, which increases the size of
the labor force, will cause the capital per
worker ratio to decrease.
• With less capital per worker, output per worker
will also be less.
• This concept reflects the principle of
diminishing returns.
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Population, Growth,
Government, and Trade
PRINCIPLE of Diminishing Returns
Suppose output is produced with two or more
inputs and we increase one input while
holding the other input or inputs fixed.
Beyond some point—called the point of
diminishing returns—output will increase at a
decreasing rate.
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Population, Growth,
Government, and Trade
• Assuming that households save a fixed fraction of
their income, an increase in taxes will cause
savings to fall.
• As the government drains savings from the private
sector, the amount of total investment decreases,
and there is less capital deepening.
• This occurs when the government uses the taxes
collected from the private sector to engage in
consumption spending, not investment.
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Population, Growth,
Government, and Trade
• If the government taxes the private sector to
increase investment, it is promoting capital
deepening.
• The foreign sector can also play a role. An
economy can run a trade deficit and import
investment goods to aid capital deepening. It can
finance the purchase of those goods by borrowing
and, as investment raises, GDP and economic
wealth rises, and the country can afford to pay
back the borrowed funds.
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The Key Role of
Technological Progress
• Technological progress is the ability of an
economy to produce more output without
using any more inputs.
• With higher output per person, we enjoy a
higher standard of living.
• Technological progress, or the birth of new
ideas, is what makes us more productive. Per
capita output will rise when we discover new
and more effective uses of capital and labor.
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How Do We Measure
Technological Progress?
• Robert Solow, a Nobel laureate in
economics from MIT, developed a method
for determining the contributions to
economic growth from increased capital,
labor, and technological progress, called
growth accounting.
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How Do We Measure
Technological Progress?
Y = F(K,L,A)
• Increases in A represent technological
progress, or more output produced from the
same level of inputs, K and L.
• We can measure technological progress
indirectly by observing increases in capital,
labor, and output.
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How Do We Measure
Technological Progress?
Percentage Contributions to Real GDP Growth
Technological
Progress
35%
Capital Growth
19%
Labor Growth
46%
Sources of Real GDP
Growth, 1929-1982
(average annual percentage rates)
Due to capital growth
0.56
Due to labor growth
1.34
+ technological progress
1.02
Output growth
2.92
• Total output grew at a rate of nearly 3%.
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How Do We Measure
Technological Progress?
Percentage Contributions to Real GDP Growth
Technological
Progress
35%
Capital Growth
19%
Labor Growth
46%
Sources of Real GDP
Growth, 1929-1982
(average annual percentage rates)
Due to capital growth
0.56
Due to labor growth
1.34
+ technological progress
1.02
Output growth
2.92
• Because capital and labor growth are measured at
0.56% and 1.34%, respectively, the remaining portion
of output growth, 1.02%, must be due to technological
progress.
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Growth Accounting: Two Examples
• From 1980 to 1985, the economies of Hong
Kong and Singapore both grew at impressive
rates of about 6%, yet the causes and results
of growth in each country were very different.
• Singapore’s growth was attributed to increases
in labor and capital, while in Hong Kong
technological progress was the key to growth.
• Residents of Hong Kong could enjoy the same
level of GDP but consume, not save, a higher
fraction of their GDP.
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Understanding Labor Productivity
• Labor productivity is defined as output per
hour of work for the economy as a whole.
• It measures how much a typical worker can
produce with the current amount of capital and
given the state of technological progress.
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U.S. Annual Productivity Growth,
1959-2000
Years
1959-1968
1968-1973
1973-1980
1980-1986
1986-1994
1994-2000
Annual Growth Rate (%)
3.5
2.5
1.2
2.1
1.4
2.5
• A significant slow-down in productivity in the
United States since 1973 meant slow growth
in real wages and in GDP.
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U.S. Annual Productivity Growth,
1959-2000
Years
1959-1968
1968-1973
1973-1980
1980-1986
1986-1994
1994-2000
Annual Growth Rate (%)
3.5
2.5
1.2
2.1
1.4
2.5
• In recent years, there has been a resurgence
in productivity growth, which reached 2.5%
from 1994-2000.
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Real Hourly Earnings and Total
Compensation in the United States
• Employees
received lower
wages but higher
benefits through
the 1980s.
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Real Hourly Earnings and Total
Compensation in the United States
• The rate of
growth of total
compensation
was less than the
growth rate of
real hourly
earnings in the
pre-1973 period.
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Labor Productivity
• The slowdown in labor productivity, in the
United States and abroad, cannot be
explained by reduced rates of capital
deepening or changes in the quality and
experience of the labor force.
• The failure of productivity growth to increase
despite rapid investment in new technology is
a mystery that has baffled many economists.
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What Causes Technological Progress?
•
Research and development in science.
•
Government or large firms who employ
workers and scientists to advance physics,
chemistry, and biology are engaged in
technological progress in the long run.
•
The United States has the highest
percentage of scientists and engineers in the
labor force in the world.
•
Not all technological progress is “high tech.”
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Research and Development as a
Percent of GDP, 1998
3.5
3.06
3.0
Total
Nondefense
3
2.58
Percent
2.5
2.29
2.2
2.2
2.18
2
2.0
1.83
1.64 1.6
1.6
1.5
1.02
1.0
1
0.5
U.S.
Japan
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Germany
France
U.K.
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Italy
Canada
O’Sullivan/Sheffrin
What Causes Technological Progress?
• Monopolies that spur innovation (Joseph
Schumpeter).
• The process by which competition for monopoly
profits leads to technological progress is called
creative destruction by Schumpeter.
• By allowing firms to compete to be monopolies,
society benefits from increased innovation.
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What Causes Technological Progress?
• The scale of the market.
• Adam Smith stressed the importance of the size
of a market for economic development.
• There are more incentives for firms to come up
with new products and methods of production in
larger markets.
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What Causes Technological Progress?
• Induced innovations.
• Some economists emphasize that innovations
come about through inventive activity designed
specifically to reduce costs.
• Education and the accumulation of knowledge.
• Modern theories of growth that try to explain the
origins of technological progress are know as
new growth theory.
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Human Capital
• Human capital is an investment in human
beings—in their knowledge, skills and health.
• In terms of understanding economic growth,
human capital investment has two implications:
• Not all labor is equal. Individuals with more
education will, on average, be more
productive.
• Health and fitness affect productivity. If
workers are frail and ill, they can’t contribute
much to national output.
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Appendix:
A Model of Capital Deepening
• The Solow model shows that:
• Capital deepening, the increase in the stock
of capital per worker, will occur as long as
total saving exceeds depreciation. Capital
deepening results in economic growth and
increased real wages.
• Eventually, the process of capital deepening
will come to a halt as depreciation catches
up with total saving.
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Appendix:
A Model of Capital Deepening
• A higher saving rate will promote capital
deepening. If a country saves more, it will
have a higher output (until the process of
economic growth through capital deepening
ends).
• Technological progress not only directly
raises output but also allows capital
deepening to continue.
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Diminishing Returns to Capital
• The relationship
between output and
the stock of capital,
holding the labor
force constant,
shows that as the
stock of capital
increases, output
increases at a
decreasing rate.
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Appendix:
A Model of Capital Deepening
PRINCIPLE of Diminishing Returns
Suppose output is produced with two or more
inputs and we increase one input while
holding the other input or inputs fixed.
Beyond some point—called the point of
diminishing returns—output will increase at a
decreasing rate.
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Appendix:
A Model of Capital Deepening
• Output increases with the stock of capital, and
the stock of capital increases as long as gross
investment exceeds depreciation.
• Without a government or a foreign sector,
saving equals gross investment. To determine
the level of investment, we need to identify
how much of output is saved and how much is
consumed.
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Saving and Depreciation as Functions
of the Stock of Capital
• The Solow model
involves these
essential relationships:
• Output (Y) as a
function of the stock
of capital (K).
• Saving as a function
of the stock of
capital (sY).
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Saving and Depreciation as Functions
of the Stock of Capital
• Total depreciation as
a function of the
stock of capital (dK),
where d is the
depreciation rate per
year, which is
constant and
proportional to the
stock of capital (K).
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Saving and Depreciation as Functions
of the Stock of Capital
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Basic Growth Model
Change in the stock of capital = sY - dK
• At K0, sY > dK then K
will rise.
• At K1, sY > dK then K
continues to rise.
• At K*, sY = dK then K
no longer increases.
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Basic Growth Model
• As long as total saving
exceeds depreciation,
economic growth
through capital
deepening continues.
• This process continues
until the stock of capital
reaches its long-run
equilibrium K*.
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Increase in the Saving Rate
• A higher saving rate
will lead to a higher
stock of capital in the
long run.
• Starting from an
initial capital stock of
K1, the increase in
the saving rate leads
the economy to K2.
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Technological Progress and Growth
• Technological
progress shifts up the
saving schedule and
promotes capital
deepening.
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