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Frank & Bernanke
Ch. 8: Economic Growth,
Productivity, and Living Standards
Source: http://www.economist.com/displayStory.cfm?story_id=346598
Source: http://hdr.undp.org/reports/global/2002/en/indicator/indicator.cfm?File=indic_290_1_1.html
http://hdr.undp.org/statistics/highlights/
Compound Interest

Suppose you put $100 in a savings account for
your retirement. How much would you have
in 50 years?
 You need to know the interest rate.
 At 1%, the savings at the end of one year will
be: 100 + 100*.01 = 100 (1+.01) = 101.
 At the end of two years, the savings will be:
100(1.01) + 100(1.01)(.01) = 100(1.01)(1.01)
= 100 (1.01)2
Compound Interest
1%
Beginning Balance 100.00
After one year
101.00
After ten years
110.46
After 30 years
134.78
After 50 years
164.46
2%
100.00
102.00
121.90
181.14
269.16
4%
8%
10%
100.00 100.00 100.00
104.00 108.00 110.00
148.02 215.89 259.37
324.34 1,006.27 1,744.94
710.67 4,690.16 11,739.09
Impact on Living Standards

GDP per capita grew at a rate of 2% per
year for US during the last 50 years.
 Japanese GDP per capita grew at a rate of
5% during the same period.
 Chinese GDP per capita grew about 8% per
year the last twenty years.
Real GDP per Capita

Real GDP per capita is found by dividing the
Real GDP by the population: Y/POP.
 We can rewrite Y/POP as Y/N times N/POP,
since the Ns would cancel out when the two
terms are multiplied.
 Y/N is average labor productivity.
 N/POP is employed portion of the population.
Growth Rate of Y/POP

Percentage growth of Y/POP will be equal
to percentage growth of Y/N (Average
Labor Productivity) PLUS N/POP (Share of
population employed).
 We can get these numbers for US from
government web sites: Bureau of Labor
Statistics, Bureau of Economic Analysis,
Federal Reserve Bank of St. Louis.
70000
60000
50000
40000
30000
20000
10000
0
1945
1955
1965
1975
GDP/cap
1985
1995
2005
AvLabProd
N/POP
0.600
0.500
0.400
0.300
0.200
0.100
0.000
1945
1955
1965
1975
1985
1995
2005
US Experience and Forecast

Why did N/POP increase during the last 30
years?
 What is expected for the future of N/POP?
 How can US expect to raise average living
standards in the future?
Determinants of Average Labor
Productivity

Human Capital
 Physical Capital
 Natural Resources
 Technology
 Entrepreneurship and Management
 Political and Legal Environment
Human Capital

Human capital of workers includes the
– Talents
– Education
– Training
– Skills
Physical Capital

Quantity and quality of machines, tools,
equipment and buildings affect the
productivity of labor.
– How productive is a computer programmer
without a computer?
– Using MB vs. MC principle to allocate
machinery.
– Diminishing returns reduces the MB for the
next machine.
Natural Resources

Abundant land, energy, raw materials will
allow inputs to be cheap for producing
certain products, giving a country
comparative advantage in these products.
 Free trade practically frees a country from
the yoke of lack of natural resources.
Technology

New technologies that increase the
productivity of labor is commonplace in our
age.
 New ways of organizing, presenting,
sequencing, etc. are also considered
technological advances.
 Technological improvements in one area
may have positive spillover effects in
another industry.
Entrepreneurship and
Management

Entrepreneurs take risks to introduce new
products, new processes into the economy.
 Societies that provide secure property
rights, low and predictable taxation and
independent, incorruptible legal system
support the flourishing of entrepreneurial
activity. (See M. Olson, Power and
Prosperity.)
Entrepreneurship and
Management

China in the Middle Ages was far superior
to the West technologically. However, the
social system stifled economic growth:
application of technology to production.
 Management is every day operation of the
establishment. Education is supposed to
reduce the incidences of wrong decisions in
everyday operations.

Political and Legal
Environment
It is the function of the government to
provide an environment where individuals
and firms are not subjected to arbitrary rules,
increasing the uncertainty of efforts.
 Enforceable contracts, well-defined property
rights, political and social environment
conducive to taking risks in production are
responsibilities of governments.
 Soviet example.
Worldwide Productivity
Slowdown

Starting with 1973, industrialized nation
experienced a significant productivity
slowdown.
 Slow growth brings social problems.
 Redistribution can exacerbate these
problems.
Why Did Productivity Slow
Down?

Decline in public education?
 Oil price shocks?
 Poor measurement of productivity gains in
service sector?
 The exceptional experience of the 50s and
60s?
Costs of Economic Growth

Resources allocated to capital formation
will reduce production of consumer goods.
 Unsanitary, unsafe conditions for industrial
workers (historical for US, current for many
LDCs).
 Is the sacrifice today, worth better living
conditions tomorrow?
How to Increase Growth
Rates?

The factors that determine average labor
productivity may be enhanced by public
policy.
Policies to Increase Human
Capital

Education increases human capital.
 Why does the government provide “free”
K-12 education?
– Positive externalities: Private demand does not
capture all the societal benefits.

Who should decide the content of
curriculum?
Policies to Promote Saving
and Investment

Capital stock in a country increases through
investment activities.
 Investments require resources diverted from
consumption goods to capital goods.
 If consumers do not restrict their consumption
(if they don’t save) total expenditures will
exceed the value of production and inflation
will ensue.
Policies to Promote Saving
and Investment

High rates of saving allow a country to
channel resources into capital formation.
 Governments can pass laws to promote
saving and laws to promote investment.
 Governments also can create capital stock
directly (how does it pay?)
Policies to Support R&D

Public good aspect of knowledge reduces
private investment in knowledge.
 Collective decision-making is required for
activities with higher social benefits than
individual benefits, e.g. basic research.
Legal and Political Framework

Political stability
 Free and open exchange of ideas
 Secure property rights
 Well functioning legal system
 Free markets (except for those with
significant externalities)
Limits to Growth?

Will we run out of oil (natural resources)?
– Market mechanisms: price incentives

Will we spoil the environment completely?
– Change in tastes and preferences

Can we solve the global warming problem?
– Limits to collective decision-making.
Commodity Prices
FIRST published in 1864, with figures
stretching back to 1845, The Economist's
commodity-price index is probably the
world's oldest regularly published price
index. Since October 2001, our dollarbased industrials index has risen by
76%, fuelled by Chinese demand for
raw materials and, in part, the weakness
of the dollar. Yet in real terms, industrial
commodity prices are a mere 30% of
their value in 1845
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