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Economics
TENTH EDITION
by David Begg, Gianluigi Vernasca, Stanley
Fischer & Rudiger Dornbusch
Chapter 26
Economic growth
©McGraw-Hill Companies, 2010
Economic growth
• Economic growth is often measured by
the rate of change of real GDP,
– although this has many deficiencies.
– It omits output that is not bought/sold
•e.g. leisure, pollution, congestion.
– It also neglects income distribution .
• So, higher GDP per capita does not
necessarily mean greater happiness,
– but it helps.
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The production function
• shows the maximum output that can be
produced using specified quantities of
inputs, given existing technical knowledge
Output =
f (capital, labour, land, raw materials, technology)
• This is to be read as: output is a function of
capital, labour, etc.
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Increasing output
• Capital
– output per worker may increase with
capital per worker
• Labour
– population growth
– participation rates
– human capital
• Land
– fixed supply, but quality may be
improved
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Increasing output (2)
• Raw materials
– important distinction between
•depletable resources (coal, oil)
•renewable resources (timber, fish)
• Technical knowledge
– inventions, R&D
• Economies of scale may reinforce the
long-run growth process
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Technical knowledge
• The state of technical knowledge
changes through time because of:
– inventions
– embodiment of knowledge in capital
– learning by doing
• Research and development (R&D)
– patent systems address a market
failure which otherwise would lead to
there being too little R&D.
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Growth and accumulation
• Suppose Y = A × f(K, L)
– i.e. variable inputs capital (K) and labour (L)
combine to produce a given output.
– A represents technical knowledge.
• At very low levels of income, savings may be zero
as all resources are needed for consumption.
• So capital cannot be created through investment,
• and output may not be able to grow through time.
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Theories of growth: some key terms
• Along a steady-state path
– output, capital and labour are all growing at the
same rate, so output per worker and capital per
worker are constant.
• Capital-widening
– extends the existing capital per worker to new
extra workers.
• Capital deepening
– raises capital per worker for all workers.
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The Solow (neoclassical) growth
model
• Assume
– labour grows at a constant rate n
– constant savings ratio s
– capital per worker is k; this is constant in
the steady state
– adding more capital per worker
increases output per worker (y)
– but with diminishing returns.
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The Solow (neoclassical) growth model
y
nk
y*
E
sy
nk shows the investment per
person that maintains capital
per person while labour grows
y shows output per person
sy shows both saving and
investment per person
k*
In the steady state E,
investment is just sufficient to
keep capital per person
constant at k*.
Per capita output is y*, and output and capital grow with
population.
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Capital per person, k
A higher savings rate
y
nk s'y
y**
y*
F
E
k*
sy
Suppose the original
steady state is at E.
An increase in the
savings ratio to s'
takes the economy
to a new steady state
at F.
k**
Capital per person, k
Capital per person
and output per person
have increased ...
But y** is constant, and thus the growth rate is unchanged.
Output and labour continue to grow at the rate n.
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The convergence hypothesis
• … asserts that poor countries will grow
more quickly than average, but rich
countries will grow more slowly than
average.
– i.e. poor countries should ‘catch up’
• but social and political differences may
enable some economies to catch up
more effectively than others.
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Convergence?
1998 2008
Bangladesh Poor
Ratio of
2 years
0.3
0.5
1.67
Nigeria
Poor
0.42
0.7
1.68
China
Poor
0.35
2.17
6.22
Indonesia
Poor
0.78
1.35
1.72
Turkey
Middle
3.28
5.71
1.71
S. Korea
Middle
6.23
16.8
2.7
Portugal
Middle
9.92
17.4
1.75
Spain
Rich
14.84
26.9
1.81
Ireland
Rich
15.27
40.9
2.68
Italy
Rich
21.83
31.5
1.42
UK
Rich
21.23
39.9
1.88
France
Rich
27.13
38.2
1.39
USA
Switzerland
Rich
Rich
29.92
46.17
45.2
59.4
1.61
1.29
East Asian economies
such as China and South
Korea grew very quickly
during the last 30 years.
Yet convergence cannot
be a powerful force in the
world, or the very poorest
countries would all be
growing very rapidly.
Generally, growth seems
to be fostered by two
conditions: absence of
internal strife and
openness to the world
economy.
Convergence? (2)
1987 per capita income
The ratio of per capita
income in 2008 relative
to 1987 is on the
horizontal axis, 1987
per capital income on
the vertical axis.
On average
countries that have
become rich then
grow more slowly.
Ratio of per capita incomes
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but individual country
performance can
depart significantly
from this underlying
relationship.
Convergence in the future
By 2025, China will have overtaken the USA, and by 2050 will have a significant economic
lead. With the fastest population growth and the second largest population to start with,
India will overtake the US eventually, but not before 2050.
Source: PwC
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Endogenous growth theory
• … recognises that there may be significant
externalities to capital
• Higher capital in one firm increases productivity in
other firms.
• known as ‘endogenous’ growth theory because it
suggests that growth may depend on parameters
that can be influenced by private behaviour or
public policy
– governments should subsidise human and
physical capital formation
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The costs of economic growth
• Malthus, in the 18th century, warned of limits
to growth,
– but he underestimated the potential
impact of technical change.
• The price system helps to ensure a proper
use of finite resources.
• Growth may bring costs
– pollution, congestion, poor quality of life,
• But lack of growth may impose costs also.
• The assessment of the desirable growth rate
remains a normative issue.
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Zero growth?
• The zero-growth proposal argues that, because
higher measured GNP imposes environmental costs,
it is best to aim for zero growth of measured GNP.
• This fails to distinguish between measured outputs
accompanied by social costs and measured
outputs without additional social costs. It does not
provide the correct incentives.
• when there is too much pollution, congestion,
environmental damage or stress, the best solution is
to provide incentives that directly reduce these
phenomena.
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