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Economic growth and
living standards
Long-Term Growth Trends (US)
Long-Term Growth Trends
Many developing
countries in Africa, Central
America, and South
America stagnated during
the 1980s, and have grown
slowly since.
They have fallen further
behind the United States.
Long-Term Growth Trends
Other formerly lowincome nations—Hong
Kong, Korea, Singapore,
and Taiwan are
examples—have grown
very rapidly and have
caught up or are catching
up with the United States
The problem of economic
development
 Lucas defines it as the problem of
accounting for the observed pattern,
across countries and across time, in levels
and rates of growth of per capita GDP
 Motivation: The diversity across countries
in per capita income is too great to be
believed
The problem of economic
development (contd)
 Is there some action the govmt of India could
take to grow as Japan? If so, what exactly? If
not, what is it about the nature of India that
makes it so
 Consequences for human welfare are
staggering. Once one starts to think about them,
it is hard to think about anything else!
Alternative measures of development
 United Nations Development Programme:
Development is about expanding the choices people
have to lead lives that they value
 The most basic things for human development are:




To lead long and healthy lives
Be knowledgeable
Have resources for a decent standard of living
Participate in the community
Very different income, similar HDI
Our approach
 Accounting for differences in GDP is not
the only thing that matters
 But it certainly is an important one (no
extremely poor country has a high HDI)
In the long-run small differences in
growth rates matter a lot
 Australia was much richer than Japan in 1870
 Over 1870-2000 Japan grew at an annual rate of
2.5%, while Australia grew at 1.1%
 As a result, Japan is now richer than Australia
What happens to GDP under
different growth rates?
5
4.5
4
3.5
3
2.5
2
1.5
1
0.5
0
0
10
20
30
Series growing at 2.5%
40
50
Series growing at 1.0%
60
Important questions
 Why some countries are rich and some
countries are poor (at one point in time)?
 What is the engine driving economic
growth (what is the force driving the time
series behavior of GDP)?
Methodology
 First: accounting decomposition
 Identify what makes GDP to be so different across
distinct countries
 Once we identify the force driving the cross-country
disparity we can develop more effective economic
policies and better economic models
Growth accounting
 GDP is quantity of goods produced in a
given period
 What determines how many goods can be
produced?
Inputs and technical constraints
 Inputs
 Labor (L)
 Machines (capital stock = K)
 Technical constraints
 Statistical studies suggest
Y AKL 1
gives a good representation of the aggregate technical
capabilities of an economy (where Y is maximum
output possible given inputs K and L, and a is a
positive number smaller than one)
Accounting for the observed
differences in output per worker
ALP 
Y
L

AK L 1
L

AK L 1
L L 1
K
AL
 Growth accounting divides growth in output per
worker in two components
 Growth in capital per hour of labor (K/L)
 Technological change (A)
 Implication of the above formula: Any growth not
accounted for by growth in capital is allocated to
technological change, so this category is a broad
catchall concept.


Conclusions
 That different countries have different
levels (or growth rates) of output per
worker can only be due to
 Differences in the level (or growth) of
capital per worker (K/L)
 or differences in TFP
 What is more important?
 Empirical question that can only be
answered by looking at each country’s
data
Growth Accounting (intuitive
graphical view)
Productivity Curve: relationship between
real GDP per hour of labor and the amount
of capital per hour of labor, with technology
held constant.
Growth Accounting
An increase in capital per
hour brings a movement
along productivity curve.
Technological change
shifts the productivity
curve.
Only two things matter:
Capital per hour, and
technological change
Growth Accounting
The shape of the productivity curve reflects the law of
diminishing returns.
The law of diminishing returns states that, as the
quantity of one input increases with the quantities of all
other inputs remaining the same, output increases but
ever smaller increments.
Diminishing returns
One third rule (empirical regularity)
 Robert Solow discovered that diminishing returns
are well described by the one-third rule: with no
change in technology, on the average, a 1 percent
increase in capital per hour of work brings a onethird of 1 percent increase in output per hour of
labor.
 Example: Assume technology remains fixed and
the capital stock of the US economy increases by
30%, what would you expect will happen to output
per hour as a result of this increase in capital?
Growth Accounting: An
application to the US economy
The productivity function and one-third rule can
be used to study productivity growth in the United
States.
Growth Accounting
From 1963 to 1973 a
large increase in
productivity (output per
hour) resulted from rapid
technological change and
a modest increase in
capital per worker.
Growth Accounting
From 1973 to 1983
productivity growth
slowed because the pace
of technological change
slowed down.
Capital per worker
continues to grow at a
similar pace to that of the
previous decade.
How to achieve faster growth: conclusions
from the graphical approach
Growth accounting tell us that to achive
faster economic growth we must either
increase the growth rate of capital per hour
of labor or increase the pace of technological
advance.
What policies may achieve faster growth?
Resources are scarce
 Objective now: determine which policy will
have the largest positive impact on GDP
per person (or on its growth rate).
 Data + quantitative analysis are required
to answer
Growth accounting (quantitative
apporach)
 One simple tool. Use the properties of
logarithms. In particular recall that
ln(x)-ln(y)  percentage
differencebetween x and y
 Example: If ln(GDP1)-ln(GDP2)=0.02 that
means GDP1 is approximately 2% larger
than GDP2
Accounting for cross-country ALP
disparity
ALP country x Acountry x
K country x

L country x
thus
ln
ALP country x ln Acountry x
K country x

L country x
finally,
ln
ALP
country x
ln
A
country x
ln
K country x
L country x
Accounting for cross-country
ALP disparity
Substract from both sides of
ln
ALP
country x
ln
A
country x
ln
K country x
L country x
the same equation, but applied to country y
ln
ALP country x ln
ALP country y ln
Acountry xln
Acountry y

 ln
K country x
L country x
ln
K country y
L country y
Which in words means:
Percentage difference between x and y’s ALP =
Percentage difference between x and y’s TFP +
a*(percentage difference between x and y’s capital)