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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. ©McGraw-Hill Companies, 2010 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. ©McGraw-Hill Companies, 2010 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 ©McGraw-Hill Companies, 2010 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 ©McGraw-Hill Companies, 2010 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. ©McGraw-Hill Companies, 2010 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. ©McGraw-Hill Companies, 2010 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. ©McGraw-Hill Companies, 2010 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. ©McGraw-Hill Companies, 2010 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. ©McGraw-Hill Companies, 2010 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. ©McGraw-Hill Companies, 2010 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. ©McGraw-Hill Companies, 2010 ©McGraw-Hill Companies, 2010 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 ©McGraw-Hill Companies, 2010 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 ©McGraw-Hill Companies, 2010 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 ©McGraw-Hill Companies, 2010 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. ©McGraw-Hill Companies, 2010 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. ©McGraw-Hill Companies, 2010