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Chapter 26

Chapter 26. Long-Run Economic Growth. In this chapter you will learn to. 1. Describe the costs and benefits of economic growth. 2. Describe the four fundamental determinants of growth in real GDP. 3. Explain the main elements of Neoclassical growth theory.

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Chapter 26

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  1. Chapter 26 Long-Run Economic Growth

  2. In this chapter you will learn to 1. Describe the costs and benefits of economic growth. 2. Describe the four fundamental determinants of growth in real GDP. 3. Explain the main elements of Neoclassical growth theory. 4. Describe new growth theories based on endogenous technical change and increasing returns. 5. Explain why resource exhaustion and environmental degradation create challenges for public policy directed at sustaining economic growth.

  3. The Nature of Economic Growth Sustained increases in Y* are amore powerful method of raising material living standards than the removal of recessionary gaps. Even small differences in annual growth rates can result in significant changes in living standards after many years. Consider GDP, per capita GDP, and GDP per worker.

  4. Figure 26.1 Three Aspects of Economic Growth

  5. Table 26.1 The Cumulative Effect of Economic Growth

  6. Benefits of Economic Growth 1. Rising average Material living standards 2. Alleviation of Poverty - many do not share directly in the growth - but redistribution is easier in a growing economy APPLYING ECONOMIC CONCEPTS 26.1 An Open Letter from a Supporter of the “Growth Is Good” School

  7. Costs of Economic Growth 1. Sacrifice of Current Consumption - growth is often encouraged by increasing investment and saving - this requires less consumption (opportunity cost of economic growth)

  8. Figure 26.2 The Opportunity Cost of Economic Growth

  9. The Opportunity Cost of Growth 2. Social Costs of Growth - growth usually involves the displacement of some firms and workers - this process involves real transition costs APPLYING ECONOMIC CONCEPTS 26.2 An Open Letter from a Supporter of the “Growth Is Bad” School

  10. Sources of Economic Growth The four fundamental sources of economic growth are: 1. Growth in the labour force 2. Growth in human capital 3. Growth in physical capital 4. Technological improvement Different theories emphasize different sources of growth.

  11. Established Theories of Economic Growth Focus on the Long Run We focus on the long run when real GDP is equal to potential output, Y*. We hold Y* constant and let the interest rate be determined endogenously by desired saving and desired investment.

  12. Investment, Saving, and Growth • Our model has two parts: • Investment — increases in the stock of capital — lead to increases in the future level of Y*. • Saving by households (and firms) is used to finance this investment. • - interest rate is the “price” that equilibrates this market

  13. Investment, Saving, and Growth Firms’ investment demand is negatively related to the real interest rate. National saving = private saving + public saving NS = Y* - T - C + (T - G) = Y* - C - G If C is negatively related to the interest rate, then NS is positively related to the interest rate.

  14. Figure 26.3 The Long-Run Connection between Saving and Investment

  15. Figure 26.4 Increases in Investment Demand and the Supply of National Saving

  16. Figure 26.5 Cross-Country Investment and Growth Rates Empirically, countries with high investment rates also have high growth rates.

  17. Neoclassical Growth Theory This theory begins with the idea of an aggregate production function: GDP = FT(L,K,H) - L is the total amount of labour - K is the stock of physical capital - H is the quality of human capital - T is the state of technology FT reflects the assumption that changes in technology will change the production function.

  18. Properties of the Aggregate Production Function Key assumptions about the aggregate production function are: 1. Diminishing marginal product of both K and L - when either factor is changed in isolation 2. Constant returns to scale - when both K and L are changed in equal proportions

  19. Figure 26.6 The Aggregate Production Function and Diminishing Marginal Returns

  20. Figure 26.6 The Aggregate Production Function and Diminishing Marginal Returns Holding K constant, increases in L generate positive but diminishing increments to output.

  21. Key Predictions of the Neoclassical Model 1. According to the law of diminishing returns, the MP of L eventually falls as each successive unit of L is used (for a fixed amount of other factors).  increases in population lead to increases in GDP but eventually to reductions in per capita GDP  falling material living standards

  22. Key Predictions of the Neoclassical Model 2. Diminishing MP of K also means that capital accumulation on its own brings smaller and smaller increases in real per capita GDP. 3. The assumption of constant returns to scale means that if K and L grow at the same rate there will be no improvements in material living standards.  GDP will grow but per capita GDP will be constant.

  23. The Importance of Technological Change In the Neoclassical growth model, technological change is necessary for sustained growth in living standards. Much technological change is embodied in new capital equipment.  investment is crucial LESSONS FROM HISTORY 26.1 Should Workers Be Afraid of Technological Change?

  24. Can We Measure Technological Change? Measuring technological change is difficult. • Robert Solow (MIT) • - his “growth accounting” method estimates technical change as the part of growth that is unexplained by capital accumulation or labor-force growth •  the “Solow residual”

  25. New Growth Theories Endogenous Technological Change New growth theory emphasizes the process of innovation and the incorporation of new technology: • learning-by-doing • knowledge transfer • market structure and innovation • shocks and innovation

  26. Increasing Marginal Returns New growth theories also emphasize the possibility that each new increment of investment is more productive than the last. - contrasts with the Neoclassical assumption of diminishing marginal returns. • The sources of increasing returns usually fall into one of two categories: • market-development costs • increasing returns to knowledge

  27. Are there Limits to Growth? Resource Exhaustion Current technology and resources could not support the entire world’s population at the average U.S. living standard. - but absolute limits to growth may not be relevant - technology is constantly improving, suggesting that living standards can continually improve - but technological improvements are not automatic — they do not “just happen”

  28. Are there Limits to Growth? Pollution Conscious management of pollution was unnecessary when the world’s population was one billion people, but such management has now become a pressing matter. Conclusion Growth can help the world address many problems. But further growth must be sustainable growth, which should be based on knowledge-driven technological change.

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