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Macroeconomics: Principles, Applications, and Tools
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O’Sullivan, Sheffrin, Perez
Macroeconomics: Principles, Applications, and Tools
Why Do
Economies Grow?
We take all the modern
conveniences of economic
growth for granted—television
sets, kitchen appliances,
automobiles, electronics,
central heating, indoor toilets,
electric lights, and medical
care that actually saves lives.
PREPARED BY
FERNANDO QUIJANO, YVONN QUIJANO,
AND XIAO XUAN XU
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Macroeconomics: Principles, Applications, and Tools
CHAPTER 8
Why Do
Economies Grow?
8.1
ECONOMIC GROWTH RATES
● capital deepening
Increases in the stock of capital per worker.
● technological progress
More efficient ways of organizing economic
affairs that allow an economy to increase
output without increasing inputs.
● human capital
The knowledge and skills acquired by a
worker through education and experience and
used to produce goods and services.
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8.1
ECONOMIC GROWTH RATES
 FIGURE 8.1
What Is Economic Growth?
Economic growth means
an expanded production
possibilities curve (PPC).
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O’Sullivan, Sheffrin, Perez
CHAPTER 8
Why Do
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CHAPTER 8
Why Do
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8.1
ECONOMIC GROWTH RATES
Measuring Economic Growth
● real GDP per capita
Gross domestic product per person adjusted for
changes in prices. It is the usual measure of living
standards across time and between countries.
● growth rate
The percentage rate of change of a variable
from one period to another.
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CHAPTER 8
Why Do
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8.1
ECONOMIC GROWTH RATES
Measuring Economic Growth
● rule of 70
A rule of thumb that says output will
double in 70/x years, where x is the
percentage rate of growth.
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8.1
ECONOMIC GROWTH RATES
Comparing the Growth Rates of Various Countries
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O’Sullivan, Sheffrin, Perez
CHAPTER 8
Why Do
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CHAPTER 8
Why Do
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APPLICATION
1
INCREASED GROWTH LEADS TO LESS CHILD LABOR
IN DEVELOPING COUNTRIES
APPLYING THE CONCEPTS #1: How does economic growth
affect social indicators such as child labor?
Economists have studied the factors that lead to changes in child labor in
developing countries:
• Most child labor occurs in agriculture, with parents as employers,
rather than in manufacturing plants.
• As the incomes of the parents increase, they tend to rely less on
their children and more on substitutes for child labor, such as
fertilizer and new machinery.
• Studies in Vietnam revealed a significant drop in child labor during
the 1990s, with the bulk of that decrease accounted for by higher
family incomes.
Their findings suggest we should think of child labor as a
phenomenon that accompanies extreme poverty and that, over time,
as economies grow, will tend to disappear.
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Macroeconomics: Principles, Applications, and Tools
CHAPTER 8
Why Do
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8.1
ECONOMIC GROWTH RATES
Are Poor Countries Catching Up?
● convergence
The process by which poorer countries close the gap with richer
countries in terms of real GDP per capita.
► FIGURE 8.2
Growth Rates versus Per
Capita Income, 1870–1979
Each point on the graph
represents a different currently
developed country. Notice that
the countries with the lowest per
capita incomes in 1870 (shown
along the horizontal axis) are
plotted higher on the graph. In
other words, the tendency was
for countries with lower levels of
initial income to grow faster.
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CHAPTER 8
Why Do
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APPLICATION
2
GROWTH NEED NOT CAUSE INCREASED INEQUALITY
APPLYING THE CONCEPTS #2: Does economic growth
necessarily cause more inequality?
Economists believed that as a country developed, inequality within a country
followed an inverted “U” pattern—a country initially increased and then narrowed
over time. Recent research challenges the assumption that this phenomenon is
solely the result of growth:
• Inequality increased from 40 percent at the beginning of the 1920s to 45
percent through the end of the Great Depression.
• During World War II the share fell to 32 percent by 1944 and remained at
that level until the early 1970s, at which time inequality began to again
increase.
• Wage and price controls during World War II reduced differentials in wages
and salaries and thereby reduced inequality.
• After the 1970s, salaries at the top of the income distribution increased
sharply.
Inequality does not naturally accompany economic development. Other factors also
play a role:
• Social norms
• Perceived fairness of compensation
• Nature of the tax system
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CHAPTER 8
Why Do
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8.2
CAPITAL DEEPENING
► FIGURE 8.3
Increase in the Supply of
Capital
An increase in the supply of
capital will shift the production
function upward, as shown in
Panel A, and increase the
demand for labor, as shown in
Panel B.
Real wages will increase from
W1 to W2, and potential output
will increase from Y1 to Y2.
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8.2
CAPITAL DEEPENING
Saving and Investment
● saving
Income that is not consumed.
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O’Sullivan, Sheffrin, Perez
CHAPTER 8
Why Do
Economies Grow?
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CHAPTER 8
Why Do
Economies Grow?
8.2
CAPITAL DEEPENING
How Do Population Growth, Government, and Trade
Affect Capital Deepening?
PRINCIPLE OF DIMINISHING RETURNS
Suppose output is produced with two or more inputs, and we increase one
input while holding the other input or inputs fixed. Beyond some point—called
the point of diminishing returns—output will increase at a decreasing rate.
► FIGURE 8.4
Taxes and Government
Investment
If the government raises taxes
by $100 and the people tend to
save 20 percent of changes in
income, then private savings
and investment will fall by $20.
However, if the government
invests the funds, then total
investment—private and
public— will increase by $80.
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CHAPTER 8
Why Do
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8.3
THE KEY ROLE OF
TECHNOLOGICAL PROGRESS
How Do We Measure Technological Progress?
● growth accounting
A method to determine the contribution to
economic growth from increased capital,
labor, and technological progress.
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CHAPTER 8
Why Do
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8.3
THE KEY ROLE OF
TECHNOLOGICAL PROGRESS
How Do We Measure Technological Progress?
► FIGURE 8.5
Contributions to Real
GDP Growth, 1929–
1982 (average annual
percentage rates)
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CHAPTER 8
Why Do
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8.3
THE KEY ROLE OF
TECHNOLOGICAL PROGRESS
Using Growth Accounting
Growth accounting is a useful tool for understanding different aspects of
economic growth.
As an example, economic growth slowed throughout the entire world during
the 1970s. Using growth accounting methods, economists typically found the
slowdown could not be attributed to changes in the quality or quantity of labor
inputs or to capital deepening. Either a slowdown in technological progress or
other factors not directly included in the analysis, such as higher worldwide
energy prices, must have been responsible. This led economists to suspect
that higher energy prices were the primary explanation for the reduction in
economic growth.
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CHAPTER 8
Why Do
Economies Grow?
APPLICATION
3
SOURCES OF GROWTH IN CHINA AND INDIA
APPLYING THE CONCEPTS #3: How can we use economic analysis to
understand the sources of growth in different countries?
China and India are the two most populous countries in
the world and have also grown very rapidly in recent
years.
From 1978 to 2004, GDP in China grew at the astounding rate of
9.3 percent per year while India’s GDP grew at a lower but still
robust rate of 5.4 percent per year.
Economists Barry Bosworth from the Brookings Institution and
Susan Collins from the University of Michigan used growth
accounting to answer this question.
Their analysis revealed that China’s more rapid growth was
primarily caused by more rapid accumulation of physical capital
and more rapid technological progress. China invested much more
than India in physical capital and was able to increase its
technological progress at a more rapid rate.
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Macroeconomics: Principles, Applications, and Tools
CHAPTER 8
Why Do
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APPLICATION
4
GROWTH ACCOUNTING AND INFORMATION TECHNOLOGY
APPLYING THE CONCEPTS #4: How much did the information
revolution contribute to U.S. productivity growth?
 FIGURE 8.6
U.S. Annual Productivity Growth, 1959–2007
In recent years, there has been a resurgence of productivity growth in part
caused by the information technology revolution.
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CHAPTER 8
Why Do
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8.4
WHAT CAUSES
TECHNOLOGICAL PROGRESS?
Research and Development Funding
▼ FIGURE 8.7
Research and Development as a Percent of GDP, 1999
The United States spends more total money than any other country on research and
development. However, when the spending is measured as a percentage of each nation’s
GDP, Japan spends more. A big part of U.S. spending on research and development is in
defense-related areas.
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CHAPTER 8
Why Do
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8.4
WHAT CAUSES
TECHNOLOGICAL PROGRESS?
Monopolies That Spur Innovation
● creative destruction
The view that a firm will try to come up with
new products and more efficient ways to
produce products to earn monopoly profits.
The Scale of the Market
Adam Smith stressed that the size of a market was important for
economic development. In larger markets, firms have more incentives
to come up with new products and new methods of production. Just as
Schumpeter suggested, the lure of profits guides the activities of firms,
and larger markets provide firms the opportunity to make larger profits.
This supplies another rationale for free trade. With free trade, markets
are larger, and there is more incentive to engage in technological
progress.
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Macroeconomics: Principles, Applications, and Tools
CHAPTER 8
Why Do
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8.4
WHAT CAUSES
TECHNOLOGICAL PROGRESS?
Induced Innovations
Some economists have emphasized that innovations come about
through inventive activity designed specifically to reduce costs. This is
known as induced innovation.
Education, Human Capital, and the Accumulation of
Knowledge
Education can contribute to economic growth in two ways. First, the increased
knowledge and skills of people complement our current investments in
physical capital. Second, education can enable the workforce in an economy
to use its skills to develop new ideas or to copy ideas or import them from
abroad.
New Growth Theory
● new growth theory
Modern theories of growth that try to explain the
origins of technological progress.
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CHAPTER 8
Why Do
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APPLICATION
5
A VIRTUOUS CIRCLE: GDP AND HEALTH
APPLYING THE CONCEPTS #6: How are economic growth and
health related to one another?
Men and women have grown taller and heavier in the last 300 years.
• An average U.S. adult male today stands at approximately 5 feet 10
inches tall, nearly 4.5 inches taller than the typical Englishman in the late
eighteenth century.
• The average weight of English males in their thirties was about 134
pounds in 1790—20 percent below today’s average.
• A typical Frenchman in his thirties at that time weighed only 110 pounds!
• Lower weights and heights were due to inadequate food supplies and
chronic malnutrition, which in turn results in a higher incidence of chronic
disease.
• In France, 20 percent of the labor force lacked enough physical energy
to put in more than three hours of light work a day.
Economic growth increased food supplies and enabled workers to become
more productive and increase GDP even more.
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CHAPTER 8
Why Do
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APLICATION
6
CULTURE AND ECONOMIC GROWTH
APPLYING THE CONCEPTS #6: Did cultural factors spark the
Industrial Revolution?
In studying the economic history of England before the
Industrial Revolution, Professor Gregory Clark discovered
an interesting fact. Examining archival data on wills and
estates, he found that children of the more affluent members
of English society were more likely to survive than those of
the less affluent. Coupled with the slow growth of population
over several centuries, this differential survival of the wealthy
had the effect of creating downward mobility for the rich, as their sons and
daughters increasingly populated the society.
According to Professor Clark, this change had profound effects on English
society. The cultural habits of the rich filtered through the entire society. Social
virtues such as thrift, prudence, and hard work became more commonplace,
while impulsive and violent behaviors were reduced. Eventually, these changes
in culture became sufficiently pronounced that a qualitative change took place
in society. Individuals now were able to take advantage of new developments
in science and technology and embrace new technologies and social change.
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CHAPTER 8
Why Do
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8.5
A KEY GOVERNMENTAL ROLE: PROVIDING THE
CORRECT INCENTIVES AND PROPERTY RIGHTS
What is the connection between property rights and economic growth?
• Without clear property rights, there are no proper incentives to invest in the
future—the essence of economic growth.
What else can go wrong?
• Governments in developing countries often:
• Adopt policies that effectively tax exports
• Pursue policies that lead to rampant inflation
• Enforce laws that inhibit the growth of the banking and financial sectors
Results:
• Fewer exports
• Uncertain financial environment
• Reduced saving and investment
With the right incentives, individuals and firms in developing countries will take
actions that promote economic growth.
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CHAPTER 8
Why Do
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APPLICATION
7
LACK OF PROPERTY RIGHTS HINDERS
GROWTH IN PERU
APPLYING THE CONCEPTS #7: Why are clear property rights
important for economic growth in developing countries?
Throughout the developing world, property is often not held with clear title.
Without clear title, property cannot be used as collateral for loans.
• Result: The poor living on very valuable land may be unable to borrow
against that land to start a new business.
• Producing palm oil in Peru is very profitable, but it depends upon the
ability to borrow funds.
• Production of coca paste—an ingredient to cocaine—does not take as
much time and does not depend on finance.
• Switching farmers away from production of coca paste to palm oil also
requires improvements in finance, which are very difficult without clear
property rights.
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Why Do
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KEY TERMS
capital deepening
labor productivity
convergence
new growth theory
creative destruction
real GDP per capita
growth accounting
rule of 70
growth rate
saving
human capital
technological progress
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Why Do
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APPENDIX
Macroeconomics: Principles, Applications, and Tools
A MODEL OF CAPITAL
DEEPENING
PRINCIPLE OF DIMINISHING RETURNS
Suppose output is produced with two or more inputs, and we increase one
input while holding the other input or inputs fixed. Beyond some point—called
the point of diminishing returns—output will increase at a decreasing rate.
► FIGURE 8A.1
Diminishing Returns to
Capital
Holding labor constant,
increases in the stock of
capital increase output,
but at a decreasing rate.
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APPENDIX
Macroeconomics: Principles, Applications, and Tools
A MODEL OF CAPITAL
DEEPENING
 FIGURE 8A.2
Saving and Depreciation as Functions of the Stock of Capital
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APPENDIX
Macroeconomics: Principles, Applications, and Tools
A MODEL OF CAPITAL
DEEPENING
► FIGURE 8A.3
Basic Growth Model
Starting at K0, saving
exceeds depreciation. The
stock of capital increases.
This process continues
until the stock of capital
reaches its long-run
equilibrium at K*.
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APPENDIX
Macroeconomics: Principles, Applications, and Tools
A MODEL OF CAPITAL
DEEPENING
 FIGURE 8A.4
Increase in the Saving Rate
A higher saving rate will lead to a higher stock of capital in the long run. Starting from an
initial capital stock of K1, the increase in the saving rate leads the economy to K2.
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O’Sullivan, Sheffrin, Perez
APPENDIX
Macroeconomics: Principles, Applications, and Tools
A MODEL OF CAPITAL
DEEPENING
 FIGURE 8A.5
Technological Progress and Growth
Technological progress shifts up the saving function and promotes capital deepening.
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