Why Do Economies Grow?

1. Why Do Economies Grow?

2. 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.

3. 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.

4. 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: • At 4% for the next ten years, GDP will be:

5. 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.

6. 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.

7. GNP per Capita and Economic Growth • Japan’s GDP per capita grew at 4.43% per year, compared to 2.13% for the United States.

8. GNP per Capita and Economic Growth • Japan’s per capita output was doubling every 16 years (recall the rule of 70) making this an extraordinary rate of growth.

9. 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.

10. Countries with Lower Incomein 1870 Grew Faster • The relationship between growth rates and per capita income in 1870 is downward-sloping. • Countries with higher levels of GDP in 1870 grew more slowly than countries with lower levels of GDP.

11. 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.

12. 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.

13. 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.

14. 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

15. 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.

16. 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.

17. 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.

18. Population, Growth,Government, and Trade PRINCIPLEof Diminishing ReturnsSuppose 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.

19. 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.

20. 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.

21. The Key Role ofTechnological 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.

22. How Do We MeasureTechnological 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.

23. How Do We MeasureTechnological 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.

24. How Do We MeasureTechnological Progress? • Total output grew at a rate of nearly 3%.

25. How Do We MeasureTechnological Progress? • 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.

26. 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.

27. 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.

28. U.S. Annual Productivity Growth,1959-2000 • A significant slow-down in productivity in the United States since 1973 meant slow growth in real wages and in GDP.

29. U.S. Annual Productivity Growth,1959-2000 • In recent years, there has been a resurgence in productivity growth, which reached 2.5% from 1994-2000.

30. Real Hourly Earnings and Total Compensation in the United States • Employees received lower wages but higher benefits through the 1980s.

31. 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.

32. 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.

33. 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.”

34. Research and Development as a Percent of GDP, 1998

35. 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.

36. 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.

37. 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.

38. 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.

39. 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.

40. 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.

41. 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.

42. Appendix:A Model of Capital Deepening PRINCIPLEof Diminishing ReturnsSuppose 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 decreasingrate.

43. 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.

44. 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).

45. 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).

46. Saving and Depreciation as Functions of the Stock of Capital

47. Basic Growth Model • At K0, sY > dK then K will rise. Change in the stock of capital = sY - dK • At K1, sY > dK then K continues to rise. • At K*, sY = dK then K no longer increases.

48. 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*.

49. 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.

50. Technological Progress and Growth • Technological progress shifts up the saving schedule and promotes capital deepening.