Download Chapter 17 Lecture Notes

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Why are some nations rich
and others poor?
© 2015 Pearson
17
Potential GDP and
Economic Growth
CHAPTER CHECKLIST
When you have completed your
study of this chapter, you will be able to
1 Explain what determines potential GDP.
2 Define and calculate the economic growth rate, and
explain the implications of sustained growth.
3 Explain the sources of labor productivity growth.
4 Describe policies that speed economic growth.
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MACROECONOMIC APPROACHES AND PATHWAYS
The Three Main Schools of Thought
The three main approaches to macroeconomics are
based on three schools of thought:
• Classical macroeconomics
• Keynesian macroeconomics
• Monetarist macroeconomics
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MACROECONOMIC APPROACHES AND PATHWAYS
MACROECONOMIC APPROACHES AND PATHWAYS
Classical Macroeconomics
According to classical macroeconomics, the market
economy works well and delivers the best available
macroeconomic performance.
Aggregate fluctuations are a natural consequence of an
expanding economy with rising living standards.
Government intervention can only hinder the ability of
the market to allocate resources efficiently.
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MACROECONOMIC APPROACHES AND PATHWAYS
MACROECONOMIC APPROACHES AND PATHWAYS
Classical macroeconomics fell into disrepute during the
1930s, which was a decade of high unemployment and
stagnant production throughout the world.
Great Depression is a decade (the 1930s) of high
unemployment and stagnant production throughout the
world economy.
Classical macroeconomics predicted that the Great
Depression would end but gave no method for ending it
more quickly.
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MACROECONOMIC APPROACHES AND PATHWAYS
Keynesian Macroeconomics
According to Keynesian macroeconomics, the
market economy is inherently unstable and it requires
active government intervention to achieve full
employment and sustained economic growth.
John Maynard Keynes, in his book “The General Theory
of Employment, Interest, and Money,” began this school
of thought.
Keynes’ theory was that too little consumer spending
and investment led to the Great Depression.
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MACROECONOMIC APPROACHES AND PATHWAYS
Keynes’ solution to depression and high unemployment
was increased government spending.
But Keynes predicted that his policy aimed at curing
unemployment in the short term might increase it in the
long term.
This prediction became reality during the 1960s and
1970s, when inflation exploded, growth slowed, and
unemployment increased.
The global recession of 2008–2009 and fear of another
great depression revived interest in Keynesian ideas.
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MACROECONOMIC APPROACHES AND PATHWAYS
Monetarist Macroeconomics
According to monetarist macroeconomics, the
classical view of the world is broadly correct, but in
addition to fluctuations that arise from the normal
functioning of an expanding economy, fluctuations in
the quantity of money also generate the business cycle.
A slowdown in the growth rate of money brings
recession and a large decrease in the quantity of money
brought the Great Depression.
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MACROECONOMIC APPROACHES AND PATHWAYS
Milton Friedman was the most prominent monetarist.
The view that monetary contractions are the sole source
of recessions is held by few economists today.
But the view that the quantity of money plays a role in
economic fluctuations is accepted by all economists and
is part of today’s consensus.
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MACROECONOMIC APPROACHES AND PATHWAYS
Today’s Consensus
Each of the earlier schools provides insights and
ingredients that survive in today’s consensus.
Classical macroeconomics provides the story of the
economy at or close to full employment.
But the classical approach doesn’t explain how the
economy performs in the face of a major slump in
spending.
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MACROECONOMIC APPROACHES AND PATHWAYS
Keynesian macroeconomics takes up the story in a
recession or depression.
When spending is cut, the demand for most goods and
services and the demand for labor decrease.
Prices and wage rates don’t fall, but the quantity of goods
and services sold and the quantity of labor employed do
fall and the economy goes into recession.
In a recession, an increase in spending by governments,
or a tax cut that leaves people with more of their earnings
to spend, can help to restore full employment.
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MACROECONOMIC APPROACHES AND PATHWAYS
Monetarist macroeconomics elaborates the Keynesian
story by emphasizing that a contraction in the quantity of
money brings higher interest rates and borrowing costs,
which are a major source of cuts in spending that bring
recession.
Increasing the quantity of money and lowering the
interest rate in a recession can help to restore full
employment.
And keeping the quantity of money growing steadily in
line with the expansion of the economy’s production
possibilities can help to keep inflation in check and can
also help to moderate the severity of a recession.
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MACROECONOMIC APPROACHES AND PATHWAYS
Another component of today’s consensus is the view that
the long-term problem of economic growth is more
important than the short-term problem of recessions.
Even a small slowdown in economic growth brings a
huge cost in terms of a permanently lower level of income
per person.
The Road Ahead
We follow the new consensus and begin with an
explanation of what determines potential GDP and the
pace at which it grows.
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17.1 POTENTIAL GDP
Potential GDP is the value of real GDP when all the
economy’s factors of production are fully employed.
We produce the goods and services that make up real
GDP by using factors of production: labor and human
capital, physical capital, land, and entrepreneurship.
At any given time, the quantities of human capital,
physical capital, land, entrepreneurship, and the state of
technology are fixed.
But the quantity of labor is not fixed.
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17.1 POTENTIAL GDP
The quantity of labor employed depends on the choices
of people and businesses.
So real GDP produced depends on the quantity of labor
employed.
To describe the relationship between real GDP and the
quantity of labor employed, we use a relationship called
the production function.
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17.1 POTENTIAL GDP
The Production Function
Production function is a relationship that shows the
maximum quantity of real GDP that can be produced as
the quantity of labor employed changes and all other
influences on production remain the same.
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17.1 POTENTIAL GDP
Figure 17.1 shows
the production
function.
100 billion hours of
labor can produce
$11 trillion of real
GDP at point A.
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17.1 POTENTIAL GDP
200 billion hours of
labor can produce
$16 trillion of real
GDP at point B.
300 billion hours of
labor can produce
$20 trillion of real
GDP at point C.
The production function
PF is a limit to what is
attainable.
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17.1 POTENTIAL GDP
The production function
is a boundary between
the attainable and the
unattainable.
The production function
displays diminishing
returns: The tendency
for each additional hour
of labor employed to
produce successively
smaller additional
amounts of real GDP.
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17.1 POTENTIAL GDP
The Labor Market
The Demand for Labor
Quantity of labor demanded is the total labor hours
that all the firms in the economy plan to hire during a
given time period at a given real wage rate.
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17.1 POTENTIAL GDP
Demand for labor is the relationship between the
quantity of labor demanded and real wage rate when all
other influences on firms’ hiring plans remain the same.
The lower the real wage rate, the greater is the quantity
of labor demanded.
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17.1 POTENTIAL GDP
The Supply of Labor
Quantity of labor supplied is the number of labor
hours that all the households in the economy plan to
work during a given time period and at a given real
wage rate.
Supply of labor is the relationship between the
quantity of labor supplied and the real wage rate when
all other influences on work plans remain the same.
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17.1 POTENTIAL GDP
The real wage rate influences the quantity of labor
supplied because what matters to people is not the
number of dollars they earn but what those dollars will
buy.
The quantity of labor supplied increases as the real
wage rate increases for two reasons:
• Hours per person increase.
• Labor force participation increases.
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17.1 POTENTIAL GDP
Labor Market Equilibrium
The price of labor services is the real wage rate.
A rise in the real wage rate eliminates a shortage of
labor by decreasing the quantity demanded and
increasing the quantity supplied.
A fall in the real wage rate eliminates a surplus of labor
by increasing the quantity demanded and decreasing
the quantity supplied.
The labor market is in equilibrium when there is no
shortage or surplus of labor.
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17.1 POTENTIAL GDP
Figure 17.2(a) shows
labor market equilibrium.
1. Full employment occurs
when the quantity of labor
demanded equals the
quantity of labor supplied.
2. Equilibrium real wage rate
is $50 an hour.
3. Full-employment quantity
of labor is 200 billion hours
a year.
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17.1 POTENTIAL GDP
Full Employment and Potential GDP
When the labor market is in equilibrium, the economy is
at full employment.
When the economy is at full employment, real GDP
equals potential GDP.
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17.1 POTENTIAL GDP
Figure 17.2(b) shows
potential GDP.
1. When the full-employment
quantity of labor is 200
billion hours a year,
2. Potential GDP is $16
trillion.
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17.2 THE BASICS OF ECONOMIC GROWTH
Economic growth is a sustained expansion of
production possibilities measured as the increase in real
GDP over a given period.
Calculating Growth Rates
Economic growth rate is the annual percentage
change of real GDP.
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17.2 THE BASICS OF ECONOMIC GROWTH
To calculate this growth rate, we use the formula:
Growth of
real GDP =
Real GDP in
Real GDP in
current year – previous year
x 100
Real GDP in previous year
For example, if real GDP in the current year is $8.4
trillion and if real GDP in the previous year was $8.0
trillion, then the growth rate of real GDP is
Growth of
real GDP =
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$8.4 trillion – $8.0 trillion
$8.0 trillion
x 100 = 5 percent.
17.2 THE BASICS OF ECONOMIC GROWTH
The standard of living depends on real GDP per person.
Real GDP per person is real GDP divided by the
population.
The contribution of real GDP growth to the change in
the standard of living depends on the growth rate of real
GDP per person.
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17.2 THE BASICS OF ECONOMIC GROWTH
We use the above formula to calculate this growth rate,
replacing real GDP with real GDP per person.
Suppose, for example, that in the current year, when
real GDP is $8.4 trillion, the population is 202 million.
Then real GDP per person is $8.4 trillion divided by 202
million, which equals $41,584.
And suppose that in the previous year, when real GDP
was $8.0 trillion, the population was 200 million.
Then real GDP per person in that year was $8.0 trillion
divided by 200 million, which equals $40,000.
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17.2 THE BASICS OF ECONOMIC GROWTH
Use these two values of real GDP per person in the
growth formula to calculate the growth rate of real GDP
per person. It is
$41,584 – $40,000
Growth rate of real
x 100 = 4 percent.
=
GDP per person
$40,000
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17.2 THE BASICS OF ECONOMIC GROWTH
The growth rate of real GDP per person can also be
calculated by using the formula:
Growth of real
= Growth rate of –
GDP per person
real GDP
Growth rate of
population
Growth of
202 million – 200 million
x 100 = 1 percent.
=
population
200 million
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17.2 THE BASICS OF ECONOMIC GROWTH
Growth of real
GDP per person = 5 percent – 1 percent = 4 percent.
This formula makes it clear that real GDP per person
grows only if real GDP grows faster than the
population grows.
If the growth rate of the population exceeds the growth
of real GDP, real GDP per person falls.
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17.2 THE BASICS OF ECONOMIC GROWTH
The Magic of Sustained Growth
Sustained growth of real GDP per person can transform
a poor society into a wealthy one. The reason is that
economic growth is like compound interest.
Rule of 70 is the number of years it takes for the level
of any variable to double, which is approximately 70
divided by the annual percentage growth rate of the
variable.
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17.2 THE BASICS OF ECONOMIC GROWTH
Table 17.1 Growth Rates
Growth rate
(% per year)
2
7
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Years for level
to double
35
10
Example
U.S. real GDP per person
China real GDP per person
17.3 LABOR PRODUCTIVITY GROWTH
To understand what determines the growth rate of real
GDP, we must understand what determines the growth
rates of the factors of production and rate of increase in
their productivity.
Real GDP growth contributes to improving our standard
of living.
But our standard of living improves only if we produce
more goods and services with each hour of labor.
So our main concern is to understand what makes labor
more productive.
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17.3 LABOR PRODUCTIVITY GROWTH
Labor Productivity
Labor productivity is the quantity of real GDP
produced by one hour of labor.
It is calculated by using the formula:
Labor productivity =
Real GDP
Aggregate hours
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17.3 LABOR PRODUCTIVITY GROWTH
For example, if real GDP is $8,000 billion and
aggregate hours are 200 billion, then we can calculate
labor productivity as
Labor productivity =
$8,000 billion
200 billion
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= $40 per hour
17.3 LABOR PRODUCTIVITY GROWTH
When labor productivity grows, real GDP per person
grows, so the growth in labor productivity is the basis of
rising living standards.
The growth of labor productivity depends on two things:
• Saving and investment in physical capital
• Expansion of human capital and discovery of new
technologies
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17.3 LABOR PRODUCTIVITY GROWTH
Saving and Investment in Physical Capital
Saving and investment in physical capital increase the
capital per worker and increase labor productivity.
But additional capital will not bring sustained economic
growth because the law of diminishing returns applies
to capital:
If the quantity of capital is small, an increase in capital
brings a large increase in production; and
If the quantity of capital is small, an increase in capital
brings a large increase in production.
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17.2 LABOR PRODUCTIVITY GROWTH
Figure 17.3 illustrates the
relationship between capital
and labor productivity.
The curve PC is the
productivity curve.
1. With a small amount of
capital an increase in the
capital brings a large
increase in real GDP per
hour of labor.
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17.2 LABOR PRODUCTIVITY GROWTH
2. With a large amount of
capital, an increase in
the capital brings a small
increase in real GDP per
hour of labor.
If capital per hour of labor
keeps increasing, labor
productivity increases by
ever smaller amounts and
eventually stops rising.
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17.2 LABOR PRODUCTIVITY GROWTH
Expansion of Human Capital and Discovery
of New Technologies
Human capital—the accumulated skill and knowledge of
people—comes from three sources:
• Education and training
• Job experience
• Health and diet
Expansion of human capital and the discovery of new
technologies has increased labor productivity.
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17.2 LABOR PRODUCTIVITY GROWTH
The discovery of new technologies has made an even
greater contribution to economic growth than the growth
of physical capital and the expansion of human capital.
Combined Influences Bring Labor
Productivity Growth
To reap the benefits of technological change, capital
must increase.
Some of the most powerful and far-reaching
technologies are embodied in human capital, but most
technologies are embodied in physical capital.
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17.2 LABOR PRODUCTIVITY GROWTH
Figure 17.4 illustrates the
effects of increased human
capital and technological
change.
The curve PC0 is the
productivity curve in 1960.
$180 of capital per hour of
labor produced $40 of goods
and services—real GDP per
hour of labor.
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17.2 LABOR PRODUCTIVITY GROWTH
The curve PC1 is the
productivity curve in 2010.
$180 of capital per hour of
labor produced $80 of goods
and services—real GDP per
hour of labor.
The expansion of human
capital and discovery of new
technologies shift the PC
curve upward and are not
subject to diminishing returns.
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17.2 LABOR PRODUCTIVITY GROWTH
Figure 17.5 illustrates how
labor productivity grows.
In 1960, workers had $80 of
capital per hour of labor and
produced $25 of real GDP
per hour of labor.
1. When capital increased to
$180 per hour of labor in
2010, real GDP per hour
of labor increased to $40.
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17.2 LABOR PRODUCTIVITY GROWTH
2. The expansion of human
capital and discovery of
new technologies shifted
the productivity curve
upward to PC1 and …
increased real GDP per
hour of labor to $80.
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17.3 LABOR PRODUCTIVITY GROWTH
Real GDP grows because labor becomes more productive
and because the quantity of labor increases.
Figure 17.6 summarizes the sources of real GDP growth.
Real GDP growth depends on quantity of labor growth
and on labor productivity growth.
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17.3 LABOR PRODUCTIVITY GROWTH
Quantity of labor growth depends on
• Population growth
• The labor force participation rate
• Average hours per worker
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17.3 LABOR PRODUCTIVITY GROWTH
Labor productivity growth depends on
• Physical capital growth
• Human capital growth
• Technological advances
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17.3 ECONOMIC GROWTH THEORIES: OLD AND NEW
What Keeps Labor Productivity Growing?
Labor productivity keeps growing because of the
choices people make in the pursuit of profit.
The new theory of economic growth emphasizes three
facts about market economies:
• Human capital grows because of choices.
• Discoveries result from choices.
• Discoveries bring profit, and competition destroys
profit.
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17.3 ECONOMIC GROWTH THEORIES: OLD AND NEW
Human Capital Expansion and Choices
People decide how long to remain in school, what to
study, and how hard to study.
Discoveries and Choices
The pace at which new discoveries are made—and at
which technology advances—is not determined by
chance.
The pace at which new discoveries are made depends
on how many people are looking for a new technology
and how intensively they are looking.
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17.3 ECONOMIC GROWTH THEORIES: OLD AND NEW
Discoveries and Profits
The forces of competition squeeze profits, so to
increase profit, people constantly seek either lower cost
methods of production or new and better products for
which people are willing to pay a higher price.
Two other facts play a key role in the new growth
theory:
• Many people can use discoveries at the same
time.
• Physical activities can be replicated.
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17.3 ECONOMIC GROWTH THEORIES: OLD AND NEW
Figure 17.7 illustrates
new growth theory in
terms of a perpetual
motion machine.
1. People want a
higher standard of
living and are
spurred by...
2. Profit incentives to
make the...
3. Innovations that
lead to...
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17.3 ECONOMIC GROWTH THEORIES: OLD AND NEW
4. New and better
techniques and
new and better
products, which
in turn lead to...
5. The birth of
new firms and
the death of
some old firms,
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17.3 ECONOMIC GROWTH THEORIES: OLD AND NEW
6. New and better
jobs, and...
7. More leisure
and more
consumption
goods and
services.
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17.3 ECONOMIC GROWTH THEORIES: OLD AND NEW
The result is...
8. A higher
standard of
living.
But people want a
yet higher
standard of living,
and the growth
process continues.
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17.4 ACHIEVING FASTER GROWTH
Preconditions for Economic Growth
Economic freedom is the fundamental precondition for
creating the incentives that lead to economic growth.
Economic freedom is a condition in which people are
able to make personal choices, their private property is
protected, and they are free to buy and sell in markets.
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17.4 ACHIEVING FASTER GROWTH
Economic freedom requires the protection of private
property—the factors of production and goods that
people own.
Property rights are the social arrangements that
govern the protection of private property.
Economic freedom also requires free markets.
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17.4 ACHIEVING FASTER GROWTH
Policies to Achieve Faster Growth
To achieve faster economic growth, we must increase
• The growth rate of capital per hour of labor or
• The growth rate of human capital or
• The pace of technological advance.
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17.4 ACHIEVING FASTER GROWTH
The main actions that governments can take to achieve
these objectives are
•
•
•
•
•
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Create incentive mechanisms
Encourage saving
Encourage research and development
Encourage international trade
Improve the quality of education
17.4 ACHIEVING FASTER GROWTH
Create Incentive Mechanisms
Economic growth occurs when the incentive to save,
invest, and innovate is strong enough. These incentives
exist only when private property is protected.
Encourage Saving
Saving finances investment, which brings capital
accumulation.
Tax incentives can encourage saving, increase the
growth of capital, and stimulate economic growth.
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17.4 ACHIEVING FASTER GROWTH
Encourage Research and Development
Everyone can use the fruits of basic research and
development efforts.
Because basic inventions can be copied, the inventor’s
profit is limited and so the market allocates too few
resources to this activity.
Governments can direct public funds toward financing
basic research, but it requires a mechanism for
allocating public funds to their highest-valued use.
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17.4 ACHIEVING FASTER GROWTH
Encourage International Trade
Free international trade stimulates economic growth by
extracting all the available gains from specialization and
trade.
Improve the Quality of Education
By funding basic education and by ensuring high
standards in skills such as language, mathematics, and
science, governments can contribute enormously to a
nation’s growth potential.
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17.4 ACHIEVING FASTER GROWTH
How Much Difference Can Policy Make?
A well-intentioned government cannot dial up a big
increase in the growth rate.
But it can pursue policies that will nudge the growth rate
upward.
And over time, the benefits from these policies will be
large.
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Political stability, property rights protected by the rule of law,
limited government intervention in markets are …
The key features of the economies that enjoy high incomes
and they are the features missing in those that remain poor.
Most of the rich nations have experienced sustained
economic growth over many decades.
Europe’s Big 4 economies (France, Germany, Italy, and the
United Kingdom) have been enjoying economic growth for
200 years.
The United States started to grow rapidly 150 years ago and
overtook Europe in the early 20th century.
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In the past 50 years,
the gaps between these
countries haven’t
changed much.
In a transition from
Communism to a
market economy,
Central Europe is now
growing faster.
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Economic growth in
Central and South
America and Africa has
been persistently slow.
The gap between the
United States and
these regions has
widened.
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Real GDP per person
in East Asian
economies has
converged toward that
in the United States.
These economies are
like fast trains running
on the same track at
similar speeds with
roughly constant gaps.
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Hong Kong and
Singapore are the lead
trains and run about
15 years in front of
Taiwan,
20 years in front of
South Korea, and
almost 40 years in front
of China.
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Between 1960 and
2010,
Hong Kong and
Singapore transformed
themselves from poor
developing economies
to take their places
among the world’s
richest economies.
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