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Economic Growth Gross Domestic Product is the market value of all final goods and services produced within a country in a given period of time. Nominal GDP is the value of the final goods and services produced ina given year valued at the prices that prevailed in that same year Real GDP is the value of the final goods and services produced in a given year when valued at constant prices. Economic growth rate is the rate of change of real GDP expressed as a percentage per year. Growth rate = Real GDP year 2 – Real GDP year 1 /Real GDP year 1 x 100 For example, if real GDP in the current year is $8.4 trillion and real GDP in the previous year was $8.0 trillion, then the growth rate of real GDP is Growth rate = Real GDP year 2 – Real GDP year 1 /Real GDP year 1 x 100 Growth rate = $8.4 trillion - $8.0 trillion / $8.0 trillion x 100 = 5% The growth rate of real GDP tells us how rapidly the total economy is expanding. But it does note tell us anything about changes in the standard of living. The standard of living depends on the real GDP per person which is Real GDP divided by the population. Example Suppose for example, that in the current year, when real GDP is $8.4 trillion, the population is 202 million. Then real GDP per capita is $8.4 trillion/202 million = $ Suppose that in the previous year, when real GDP was $8 trillion, the population was 200 million. The real GDP per capita in that year was $8.0 trillion/200 million = $ Growth rate of real GDP per capita = $ - $/$ x 100 = % 1 There is another way to calculate the growth rate of real GDP per capita. What is it? This formula makes it clear that real GDP per capita grows only if real GDP grows faster than the population growth. The Magic of Sustained Growth Rule of 70 – the number of years it takes for the level of any variable to double is approximately 70 divided by the annual percentage growth rate of the variable Growth rates Growth rate (% per year) 1 2 3 4 5 6 7 8 9 10 Years for level to double 70 35 23 18 14 12 10 9 8 7 Question Mexico’s real GDP was 1448 billion pesos in 1998 and 1501 billion pesos in 1999. Mexico’s population growth in 1999 was 1.8%. Calculate: a. Mexico’s economic growth rate in 1999 b. The growth rate of real GDP per capita in Mexico in 1999 c. The approximate number of years it takes for real GDP per capita in Mexico to double if the 1999 economic growth rate and population growth rate are maintained d. The approximate number of years it takes for real GDP per capita in Mexico to double if the 1999 economic growth rate is maintained but the population growth slows to 1% a year 2 Difference between actual and potential economic growth The economy inside the PPC Figure 3 Unemployment=Inefficient resource use The economy may be producing at some point inside the curve (producing less of both goods). There are two main reasons for this: 1 Unemployment of resources 2 Inefficient use of resources So, in figure 3 the solid curve is the PPC with full employment, while the dotted line is the PPC with unemployment. Actual growth If an economy is operating inside its PPC and produces more as a result of using previously unemployed resources, or using resources more efficiently, this is referred to as actual growth. This is illustrated in figure 4 below by a movement from a point within the PPC to a point towards or on the PPC. Figure 4 Actual growth The movement from point Z towards the PPC represents an increase in actual growth. 3 Potential growth The productive potential of an economy may be increased by an increase in the quality and/or quantity of resources and, when this occurs, this is known as potential growth. This is illustrated in figure 5 below by an outward shift of the PPC. Figure 5 Potential Growth This denotes an increase in the productive capacity or potential of the economy as more of both goods can now be produced. Difference between growth and development Economic development is a broader concept than economic growth. While economic growth is measured by the increase in a country's real level of output over time, economic development might additionally involve changes in the composition of output, a more equal distribution of income, greater access to health care etc. This difference can be illustrated using a PPC. The two previous diagrams (Figures 4 and 5) indicate an increase in economic growth through an increase in potential and actual output. Figure 6 below indicates economic development. Figure 6 Economic Development 4 The switch from PPC1 to 2 shows more of society's resources being used for the production of health care and less for the production of luxury goods. This is one indicator of economic development, providing sufficient people have access to the greater health care. Figure 7 Economic growth and development (occurring together) The PPC has shifted outwards denoting economic growth, but proportionately more of the economy's resources are now devoted to the output of health care rather than luxury goods as compared with the original position (PPC1). The productive potential of the economy has increased (economic growth) and there has been a qualitative improvement in the composition of the nation's output (economic development). Source: http://www.triplealearning.com/files/developers/a_z_economics/page_14.htm[ accessed Sunday 13th of September 2015] The sources of economic growth Real GDP grows when the quantities of the factors of production grow or when persistent advances in technology make them increasingly productive. All the influences on real GDP growth can be divided into those that increase Aggregate hours Labour productivity 5 Aggregate Hours Over time aggregate hours increase. In developed economies, this growth in aggregate hours comes from growth in the labour force rather than growth in average hours per worker. Population growth brings economic growth but it does not bring growth in real GDP per capita unless labour hours become more productive. Labour Productivity The quantity of real GDP produced by one hour of labour is called labour productivity. It is calculated by using the formula: Labour productivity = real GDP/aggregate hours For example, if real GDP is $8000 billion and if aggregate hours are 200 billion, then we can calculate labour productivity as: Labour productivity = $8000 billion/200 billion = $40 per hour You can turn this formula around and see that: Real GDP = Aggregate hours x labour productivity When labour productivity grows, real GDP per capita grows. So the growth in labour productivity is the basis of rising living standards. The growth of labour productivity depends on three things: Savings and investment in physical capital – increase the amount of capital per worker and increase labour productivity Expansion of human capital – human capital which is the accumulated skills and knowledge of people comes from education & training and job experience Discovery of new technologies – the development of writing, development of mathematics which laid the foundation for the eventual extension of knowledge in the sciences and more advanced technologies embodied in physical capital have laid the conditions for great spurts in economic growth in the last 200 years. 6 Robert Solow’s One-third rule This is an observation discovered by Robert Solow of MIT. One average, with no change in human capital and technology, a 1% increase in capital per hour of labour brings a one-third percent increase in labour productivity. We can use the one –third rule to identify the contribution of capital growth to labour productivity growth. Suppose, for example, that in a year, capital per hour of labour grows by 3% and labour productivity grows by 2.5%. The one-third rule tells us that capital growth has contributed one-third of 3% which is 1%. Labour productivity growth that is not attributed to capital growth arises from human capital growth and technological change. In the above example in which labour productivity grows by 2.5% and capital growth contributed 1%, the remaining 1.5% growth of labour productivity comes from human capital growth and technological change. Question The table provides some data on the Canadian economy in 1998 and 1999 Item Aggregate hours (billions) Real GDP (billions of 1992 dollars) Capital per hour of labour (1992 dollars) a) b) c) d) 1998 25.0 1999 25.2 840 880 127 130 Calculate the growth rate of real GDP in 1999 Calculate labour productivity in 1998 and 1999 Calculate the growth rate of labour productivity in 1999 If the one-third rule applies in Canada, what were the sources of labour productivity growth in 1999? Explain your answer 7