Chapter 12 “Economic Growth”

1. ECONOMICS: EXPLORE & APPLYby Ayers and Collinge Chapter 12“Economic Growth”

2. Learning Objectives • Identify the sources of economic growth. • Describe the role of savings and investment in the process of capital formation. • Analyze how taxation affects both savings and investment activity. • Provide justification for subsidized higher education.

3. Learning Objectives • Summarize new growth theory and supply side economics • Discuss the key role of labor productivity in economic growth.

4. 12.1THE SEEDS OF ECONOMICS GROWTH • Economic growth is measured by the change in real GDP over time. • Sometimes a GNP measure is used instead. • Economies turn resources into outputs of greater value. • Over time the possibilities for doing so expand as the economy develops new technologies, and acquires new resources.

5. Sources of Economic Growth • Most U.S. economic growth is attributable to increases in labor and capital. • Both technological change and additional capital increase labor productivity. • Increases in labor productivity means that more GDP is produced for each hour worked by by the labor force.

6. Annualized Growth Rates by Presidency

7. Sources of Economic Growth • The growth rate increases in some years, decreases in some years, and even falls in other years because of economic slowdowns. • When recession begins, labor productivity tends to fall as aggregate demand and production decrease. • When recession nears it end, production at first increases, with no corresponding increase in employment, causing productivity to rise.

8. Sources of Economic Growth • Labor productivity is associated with the amount of capital – both physical and human – labor has at its disposal. • The creation and accumulation of new capital is termed capital formation. • Capital formation requires initiative, and in market economies entrepreneurs make these choices based on profitability judgments.

9. Nurturing Growth – Savings and Investment • Capital formation requires investment, which can be coordinated centrally through government. • Investment can also be a decentralized process that responds to supply and demand in the marketplace. • Investors finance the capital formation that is necessary to take advantage of market opportunities.

10. Firms invest when they wish to do any of the following: Expand their scale of operations. Implement better production techniques. Produce new goods that their old factories are ill-suited to manufacture. Nurturing Growth – Savings and Investment

11. Nurturing Growth – Savings and Investment • To acquire human capital, individuals invest in themselves. • Savings provides the capital for investment. • Government reduces private savings and investment in two ways. • It taxes away income that might be saved. • It taxes the return on investments. • In contrast, government also adds to investment.

12. Nurturing Growth – Savings and Investment Without government, aggregate savings and investment would be the same. With government the situation is more complex because tax dollars can be directed towards government investment or government consumption. Investment + Government consumption = Savings + Taxation or, equivalently, Investment = Savings + Taxation - Government consumption

13. Nurturing Growth – Savings and Investment • Higher interest rates raise the cost of investing. • A crowding out effect occurs when government borrowing is in competition with private-sector borrowing, and thus can cause higher interest rates. • Higher interest rates decrease investment.

14. Investment is also affected by the following factors.. Business confidence Current economic growth Opportunities presented by technological change Increases in any of these variables would shift the investment demand curve to the right. Decreases would shift the investment demand curve to the left. Nurturing Growth – Savings and Investment

15. As the interest rate gets lower, businesses borrow more… Supply of savings …and people save less. At equilibrium, the amount borrowed and saved is equal. Actual Interest Rate Demand for investment Actual savings and investment The Equilibrium Interest Rate Real Interest Rate Savings and investments

16. 12.2 INFLUENCING GROWTH THROUGH PUBLIC POLICY • Private investors assess the expected return, which is the value of the investment if successful, multiplied by the probability of success. • The actual return can be viewed as ex post, meaning after the fact. • Ex post, an investment might have turned out fabulously, or might have failed miserably.

17. The Incentive Effects of Taxation • In addition to regulation, taxes can also affect growth. • A tax on savings increases the market interest rate and discourages investment. • Taxing the return to savings shifts the supply of savings to the left. • There is concern over the low personal savings rate in the U.S. in recent years.

18. The Incentive Effects of Taxation • Investment is also discouraged by other taxes such as the tax on capital gains. • Capital gains represents the difference between the current market value of an investment and its purchase price. • The capital gains tax takes a percentage of this difference when the investment is sold.

19. Supply of savings Higher interest rate A tax on savings changes the market equilibrium for savings and investment. Lower savings and investment Effects of the Income Tax Real Interest Rate Supply of savings Demand for investment Savings and investment

20. Subsidizing Research and Development • An external benefit occurs when some benefits are received by third parties who are not directly involved in a decision, such as the decision to research or invest. • Research is aimed at creating new products or otherwise expands the frontiers of knowledge and technology. • Development occurs when that technology is embodied into capital or output.

21. Subsidizing Research and Development • External benefits are most prominent at the research stage. • Especially when the research involves the creation of knowledge that can be applied to the production of many different products. • It is difficult for any one investor or group of investors to assert property rights over the range of applications that can arise from basic advances in knowledge. • To correct this market failure the government subsidizes research.

22. Subsidizing Research and Development Universities are often the source of valuable research, subsidized by government that companies fear to undertake on their own.

23. 12.3PROPERTY RIGHTS AND NEW GROWTH THEORY • The prospect for business profits in the future can lead to research and development in the present. • This idea is the cornerstone for what is called the new growth theory, which emphasizes the importance of new ideas in generating economic growth, and intellectual property rights in providing the profit incentive to generate those ideas.

24. 12.4SUPPLY-SIDE POLICY • Those economist who particularly emphasize policy aimed at growth are called supply-side economist, or supply-siders for short. • Supply-siders focus on increasing the value of what the economy can produce in the long-run (the supply side) rather than on any desire to change consumer’s spending behavior (the demand side). • Supply-siders feel that the short-run business cycle will sort itself out over time as long as the government does not intrude.

25. Supply-Side Policy • The objective of supply-side policy is to ensure that output associated with full employment is as high as possible. • Supply-side policies are designed to increase productivity, such as through increasing capital formation. • Full-employment output will change in response to changes in structural features of the economy, including resources and technology. • Structural features also include government policies that change how workers and firms behave.

26. Supply-Side Policy Critics refer to supply-side policies as trickle down economics. The term suggest that the policies were intended to make the rich richer, so that they might spend a bit more and help the rest of us. This is not the process intended by supply-siders, instead they aim at increasing productivity, not spending.

27. Supply siders aim to get more output from full employment Full-employment output Supply-Side Policy Long-run Aggregate supply Price level Real GDP

28. The Laffer Curve • Increasing tax rates will increase tax revenues, but only up to a point. • After that point, higher tax rates are self-defeating and actually reduce tax revenues. • At a rate of 100 percent, there would be no point to earning any income at all.

29. The Laffer Curve Tax Revenue Maximum Tax Revenue 0% Tax rate 100%

30. How Technology Impacts Growth • The ‘new’ U.S. economy is characterized by the application of technology to increase business productivity. • The growth of computers in the workplace increases the productivity of labor. • Throughout history, the economy has been revitalized again and again by technologies like the railroad, the automobile, radio, television, and now the computer and the Internet.

31. Sources of Changes in United States Labor Productivity 1979-2000

32. 12.5 EXPLORE & APPLYThe New Economy – Is It Real? • In the 1990’s the “new economy” was characterized by the tremendous wealth creation in the Silicon Valley. • The new economy is characterized by the application of technology to increase business productivity. • The application of computer technology has been especially significant.

33. economic growth labor productivity capital formation crowding-out effect expected return actual return capital gains capital gains tax external benefit research development property rights new-growth theory supply-side economists Terms Along the Way

34. Test Yourself • Technological change and additional capital • increase labor productivity. • decrease labor productivity. • have no effect on labor productivity. • affect labor productivity in unpredictable ways.

35. Test Yourself 2. U.S. economic growth • has generally been characterized by a 5 percent or more growth rate since the 1960’s. • varied with each president. • was on a downward trend in the 1990’s, but has recently reversed its course. • is no longer considered an important goal.

36. Test Yourself 3. Capital formation is also referred to as • property rights. • technology . • the real interest rate. • investment.

37. Test Yourself 4. Investment equals • savings + taxation. • savings + taxation. • savings + taxation + government consumption. • savings + taxation – government consumption.

38. Test Yourself 5. Higher real interest rates • increase the amount of investment. • decrease the amount of investment. • have no effect on the amount of investment. • have varying and unpredictable effects on investment.

39. Test Yourself 6. The Laffer curve shows that the effect of increasing taxes too much is • less economic growth. • less tax revenue. • more unemployment. • that only the rich get richer.

40. The End! Next Chapter 13 “Money, Banking, and the Federal Reserve"