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Chapter 7

Chapter 7. Economic Growth. The Economy in the Long Run. Learning Objectives. Show how small differences in growth rates lead to large differences in living standards Explain why GDP per capita is average labor productivity times the proportion of the population employed

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Chapter 7

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  1. Chapter 7 Economic Growth

  2. The Economy in the Long Run

  3. Learning Objectives • Show how small differences in growth rates lead to large differences in living standards • Explain why GDP per capita is average labor productivity times the proportion of the population employed • Use this to discuss the sources of growth • Discuss the determinants of average labor productivity • Understand the trade-offs between economic growth and environmental quality

  4. Benefits of Growth • In the late 18th and early 19th century • Life expectancy was 40 years • Most families had 2 or 3 children die • Nothing moved faster than the speed of a horse • The best highway was from Boston to New York • A stagecoach made the 175-mile trip in 3 days • Pace of technical change is accelerating • Inventions are not sufficient to create growth • Products must be commercialized and sold

  5. Real GDP per Person, 1870-2003 (in 2000 US Dollars)

  6. Real GDP per Capita, 1870 - 2003

  7. Growth of Real GDP per Capita, 1870 - 2003

  8. Compound Interest Rates • In 1870, Brazil's GDP per capita was twice Ghana's • By 2003, the multiple increased to 5 times • Brazil's growth over the period was 1.6% and Ghana's was 0.9% • Compound interest pays interest on the original deposit and all previously accumulated interest • Interest paid in year 1 earns interest in year 2 • $10 deposited at 4% interest in 1800 is $31,033.77 in 2005 • $10 x (1.04)205 = $31,033.77

  9. Compound Interest • Differences in interest rates matter • Growth rates in GDP per capita have the same effect as interest rates • Relatively small growth in GDP per capita has a very large effect over a long period • In the long run, the growth rate of an economy matters

  10. Real GDP per Capita • Notation • Y = real GDP • N = number of people employed • POP = population • GDP per capita is the product of output per worker and the share of population employed • Consumption per person depends on • How much each worker produces and • The share of people working

  11. Understanding Growth • GDP per capita increases when • Output per worker (Y / N) increases OR • The share of the population employed (N / POP) increases • Between 1960 and 2007, • GDP per capita increased 172% • Output per worker increased 110% • The share of the population employed increased from 36% to 48% • Baby boomers in their working age • Increasing female labor force participation

  12. Y / POP and Y / N, 1960 - 2006

  13. N / POP, 1960 - 2006

  14. Understanding Growth The rising share of the population employed is transitory. In the long run, increases in output per person arise primarily from increases in average labor productivity (output per worker).

  15. Average Labor Productivity • US average labor productivity is • 24 times Indonesia's • 100 times Bangladesh's • Six factors determine average labor productivity • Human capital • Physical capital • Land and other natural resources • Technology • Entrepreneurship and management • Political and legal environment

  16. Physical Capital • More and better capital increases worker productivity • Factory owner employs two people and adds capital • Each machine requires one dedicated operator • More capital increases output per hour • Diminishing returns to capital

  17. Diminishing Returns to Capital • Diminishing returns to capital occurs if an addition of capital with other inputs held constant increases output by less than the previous increment of capital • Assumption: all inputs except capital are held constant • Result: output increases at a decreasing rate • When a firm has many machines, the most productive uses have already been filled • The increment in capital will necessarily be assigned to a less productive use than the previous increment • Principle of Increasing Opportunity Cost

  18. Growth and Diminishing Returns to Capital • Implications of diminishing returns • Increasing capital will increase output and labor productivity • Positive contribution to growth • There are limits to increasing productivity by adding capital because of diminishing returns

  19. Capital and Output per Worker, 1990 High capital/worker,High GDP per worker Low capital/worker,Low GDP per worker

  20. Trade-offs between economic growth and environment • Research indicates that pollution increases up to a point with increased GDP per person • After A, air pollution decreases and air quality improves • Estimates suggest Mexico is close to point A • Beyond a certain level of income, citizens value a cleaner environment and they are willing and able to pay for it A Air pollution Real GDP per capita

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