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Chapter 26
Long-Run
Economic
Growth
Copyright © 2011 Pearson Canada Inc.
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In this chapter you will learn...
1. …about the costs and benefits of economic growth.
2. …the four fundamental determinants of growth in real GDP.
3. …the main elements of Neoclassical growth theory.
4. …about new growth theories based on endogenous
technical change and increasing returns.
5. …why resource exhaustion and environmental degradation
create serious challenges for public policy directed at
sustaining economic growth.
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26.1 The Nature of Economic
Growth
Sustained increases in Y* are more powerful method of
raising material living standards than the removal of
recessionary gaps.
Even small differences in annual growth rates can result in
large changes in living standards after many years.
Consider GDP, per capita GDP, and GDP per worker.
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Could be GDP, per capita GDP, GDP per worker, or your savings
account - any variable that grows over time.
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Average annual
rate of growth
About 3.5%
About 2.5%
About 1.5%
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Benefits of Economic Growth
1. Rising average 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
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Costs of Economic Growth
1. Sacrifice of Current Consumption
- growth is often encouraged by increasing investment
and saving
- which requires less consumption
 the opportunity cost of growth
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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
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We have been discussing the benefits of economic growth –
sustained increases in per capita incomes. Some modern
research, however, suggests that rising income is less important
for people’s happiness than traditionally thought. For more
information, go to What Makes People Happy? in the
Additional Topics section of this book’s MyEconLab.
www.myeconlab.com
Copyright © 2011 Pearson Canada Inc.
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Sources of Economic Growth
The four fundamental sources of economic growth are:
1. Growth in the labour force.
F
2. Growth in human capital.
F quality (productivity)
3. Growth in physical capital.
F
4. Technological improvement.
productivity
Different theories emphasize different sources of growth.
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26.2 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
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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
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Firms’ investment demand is negatively related to the real
interest rate.
National saving = private saving + public saving
 NS = Y* - T - C + (T - G)
 NS = Y* - C - G
If C is negatively related to the interest rate, then NS is
positively related to the interest rate.
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NS = Y*-C-G
Excess
Supply
•
i1
i*
i2
•
•
•
E
Excess
Demand
I*=NS*
•
I
With Y = Y*, the
condition that desired
national saving equals
desired investment
determines the
equilibrium interest
rate.
Loanable Funds
At point E, the market for loanable funds clears and the
equilibrium real interest rate is i*.
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Suppose the supply of national saving increases:
 the NS curve shifts to the right
Increased national saving
reduces the real interest
rate and encourages more
investment
NS0
NS1
- change in tax laws
E0
i0*
i1*
•
- change in taste
- gov’t surpluses
•
E1
I0* I1*
I
Loanable Funds
Greater flow of investment
leads to a higher growth rate
of potential output.
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Now suppose that investment demand increases
 the I curve shifts to the right
Increased investment demand
pushes up the interest rate and
encourages more saving by
households
NS
i1*
i0*
E0
•
- new products/technology
- change in expectations
• E1
I1
I0
I0* I1*
Greater flow of saving (and
investment) leads to a
higher growth rate of Y*.
Loanable Funds
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Empirically, countries with high investment rates also
have high growth rates.
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We have been discussing the relationship between investment
and saving in a model of a closed economy. In the reality of
today’s globalized financial markets, however, billions of dollars
of financial capital flow across international boundaries every
day. For more details about how our model can be modified for
an open economy, look for Investment and Saving in
Globalized Financial Markets in the Additional Topics section
of this book’s MyEconLab.
www.myeconlab.com
Copyright © 2011 Pearson Canada Inc.
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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 (including natural resources)
- H is the quality of human capital
- T is the state of technology
The notation FT reflects the assumption that changes in
technology will change the production function.
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The 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
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40
Units of
Output
APL
MPL
1
12.0
12.0
2
17.0
8.5
5.0
3
20.8
6.9
3.8
4
24.0
6.0
3.2
15
5
26.8
5.4
2.8
10
6
29.4
4.9
2.6
7
31.9
4.6
2.5
8
34.0
4.2
2.1
9
36.0
4.0
2.0
10
37.9
3.8
1.9
Units of Output
L
•
35
•
•
30
•
25
20
TP
•
2
4
6
8
10
Units of Labour
Holding K constant, increases in L
generate positive but diminishing
increments to output.
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What are the central predictions for this model?
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
MP of L falling implies AP of L is falling
 falling average living standards
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Average Product
of Labour
With K fixed and Technology fixed
as we add more and more Labour
the average product of labour
eventually begins to decline
Economically optimum
level of population
under populated
over populated
We can define an economically
optimum population as one that
maximizes the APL (GDP per capita)
Given its other factor resources
and technology a society can
be over populated or under
populated
APL
Population
Labour force = σ population
where σ is the participation rate
In this sense, Canada throughout most of its history has been under
populated. That is why we have always encouraged immigration
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Average Product
of Labour
Can the APL curve shift?
Yes, it can shift up and out if
there is technological change
(improvement).
Society can get more output
for a given amount of inputs.
APL
Population
Labour force = σ population
APL (GDP per capita) increases
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Average Product
of Labour
Can the APL curve shift?
The APL curve can also shift to the
right if there is increased K (but with
constant returns to scale – ‘bigger is
not better’).
Economies of scale have been
exhausted – a mature economy.
APL
Population
Labour force = σ population
The economy gets bigger but APL (GDP per capita) does not increase
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Average Product
While we are on this point! of Labour
Thomas Malthus was an English
Philosopher writing in the early
1800’s who believed that
Subsistence
the masses were doomed to level of income
exist at a subsistence level
of income.
APL
Capital and Land were relatively fixed
– as they were in the late 1700’s early 1800’s
Population
But the population kept growing so that
Labour force = σ population
eventually average incomes would fall below
The subsistence level of income
– famine and disease would set in until the population
decreased reversing the fall in incomes – and the cycle would continue
Malthus believed that this would continue repeating itself over and over.
Irish famine was considered an example of this. Dismal Science indeed!
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Average Product
of Labour
So why was Malthus wrong?
Something occurred in the
Western world which had Subsistence
never really occurred before level of income
– the Industrial Revolution –
very high rates of technical
change and very high rates of
investment
The APL curve began to shift out
APL
Population
Labour force = σ population
Productivity began to grow faster than
population growth and therefore average incomes began to grow even as
population grew.
The western world has never looked back. We have not had a really good
famine in the west since the 1800’s (except for starvation caused by war or
natural catastrophe.)
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Back to our model of long run growth
Recall, diminishing MP of K means that capital accumulation on its own
brings smaller and smaller increases in real per capita GDP – diminishing
marginal returns to K.
Finally, 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.
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Average Product
of Labour
In terms of Average Product
of labour
The economy can keep
getting bigger – more capital
and more labour – but it does
not get any better – no
increase in APL (no increase
in living standards – GDP per
capita)
APL
Population
Labour force = σ population
The APL curve just keep shifting to the right as more labour and capital
are added – we technical change to make the APL curve shift upwards.
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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
Measuring the extent of technological change is difficult –
because it is not directly observable.
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In the Neoclassical growth model, technological change is necessary for
sustained growth in living standards – for mature economies. What about
LDC’s?
But the process of technical change itself is not explained.
Technical change is exogenous in the Neoclassical Growth Model.
All the can be said is that much technological change is embodied in new
capital equipment
 investment is crucial
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Robert Solow (MIT)
- his “growth accounting” method estimates technical change as
the part of growth that is unexplained by capital accumulation or
labour-force growth
 the “Solow Residual”
The most important element of the growth model for mature
economies remains a mystery in the Neoclassical Growth
Model
LESSONS FROM HISTORY 26-1
Should Workers Be Afraid
of Technological Change?
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The aging of Canada’s baby-boom generation over the next three
decades will lead to a reduction in Canadian economic growth and
will produce challenges for Canadian governments. For more
details, see The Economic and Fiscal Challenges of Population
Aging in the Additional Topics section of this book’s MyEconLab.
www.myeconlab.com
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26.3 New Growth Theories
Endogenous Technological Change
New growth theory emphasizes the process of innovation and
the incorporation of new technology:
• learning-by-doing
‘the more you do the more you can do’
• knowledge transfer
‘hands on’ experience
• market structure and innovation
• shocks and innovation
competitive pressure
spur innovation
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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
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Increasing Marginal Returns
• market-development costs (all of these decrease cost as
more and more investment is made)
• Externalities in factor supplies as the investment grows
• Development of infrastructure as investment grows
• Fixed start-up design and production cost are less as investment
grows
• increasing returns to knowledge
•The ‘public good’ nature of new ideas (as opposed to physical
goods) – and ‘idea’ economy grows faster than a ‘goods’ economy
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26.4 Are There Limits to Growth?
Resource Exhaustion
Current technology and resources could not support the entire
world’s population at the average Canadian standard of living.
- 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”
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Environmental Degradation
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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APPLYING ECONOMIC CONCEPTS 26-3
Climate Change and Economic Growth
Many of the insights about the determinants of economic growth that we
explored in this chapter apply also to economic growth in the developing
countries. But the developing countries also have some unique economic
and institutional challenges, some which have plagued them for many
years. For a detailed discussion, look for Challenges Facing the
Developing Countries in the Additional Topics section of this book’s
MyEconLab.
www.myeconlab.com
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