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Chapter 24
Long-Run Economic Growth
and Business Cycles
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Economic Principles
Capital-labor and capital-output
ratios
Technology and labor productivity
Labor productivity and economic
growth
Saving, investment, and economic
growth
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Economic Principles
External and internal theories
of the business cycle
The interaction of the
multiplier and accelerator
Countercyclical fiscal policy
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Long-Run Economic Growth
Economic growth
• An increase in real GDP, typically expressed
as an annual rate of real GDP growth.
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Long-Run Economic Growth
In The Wealth of Nations, Adam
Smith identified four principal
factors that contribute to a nation’s
economic growth. What are they?
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Long-Run Economic Growth
Principal factors that contribute to a
nation’s economic growth:
a. The size of its labor force
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Long-Run Economic Growth
Principal factors that contribute to a
nation’s economic growth:
a. The size of its labor force
b. The degree of labor specialization
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Long-Run Economic Growth
Principal factors that contribute to a
nation’s economic growth:
a. The size of its labor force
b. The degree of labor specialization
c. The size of its capital stock
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Long-Run Economic Growth
Principal factors that contribute to a
nation’s economic growth:
a. The size of its labor force
b. The degree of labor specialization
c. The size of its capital stock
d. The level of its technology
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EXHIBIT 1
U.S. ECONOMIC PERFORMANCE: 1900–2000
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Exhibit 1: U.S. Economic
Performance: 1900-2000
In what time period between 1900
and 2000 was there the greatest
rate of economic growth in the
U.S.?
• During the first half of the 1940s when
the U.S. was fighting World War II.
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Long-Run Economic Growth
Capital-labor ratio
• The ratio of capital to labor, reflecting the
quantity of capital used by each laborer in
production.
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EXHIBIT 2
LONG-RUN ECONOMIC GROWTH
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Long-Run Economic Growth
2. If capital is $50,000 and labor is
200, what is the capital-labor ratio?
• The capital-labor ratio is ($50,000/200)
= $250.
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Long-Run Economic Growth
Labor productivity
• The quantity of GDP produced per
worker, typically measured in quantity of
GDP per hour of labor.
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Long-Run Economic Growth
3. If real GDP increases from
$10,000 to $12,000, and labor rises
from 100 to 105, what has
happened to labor productivity?
• Output per laborer rises from
($10,000)/100 = $100 to ($12,000)/105
= $114.29.
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Long-Run Economic Growth
Capital deepening
• A rise in the ratio of capital to labor.
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Long-Run Economic Growth
4. Which of the following represents
capital deepening?
a. Increased worker experience
b. Increased worker training
c. Increased capital-labor ratio
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Long-Run Economic Growth
4. Which of the following represents
capital deepening?
a. Increased worker experience
b. Increased worker training
c. Increased capital-labor ratio
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EXHIBIT 3
THE LABOR PRODUCTIVITY CURVE
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Exhibit 3: The Labor
Productivity Curve
How does capital deepening affect
labor productivity?
• The more capital per laborer, the greater
the laborer’s productivity. Moreover, new
technology can shift upwards the labor
productivity curve.
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Long-Run Economic Growth
Capital-output ratio
• The ratio of capital stock to GDP.
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Long-Run Economic Growth
According to Adam Smith and
many economists today, savings
automatically convert to
investment spending, so that
investment-induced growth is
dependent on savings.
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Long-Run Economic Growth
Changes in technology can
increase labor productivity and
GDP without there being any
change in the value of the capital
stock.
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EXHIBIT 4
THE GROWTH PROCESS
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Exhibit 4: The Growth Process
1. According to Exhibit 4, what will
happen to consumption and
investment next year as a
consequence of investment this year?
• Investment this year increases next year’s
capital stock, which in turn generates an
increase in next year’s consumption and
investment spending.
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Exhibit 4: The Growth Process
2. What will happen to potential
future economic growth if more
of GDP is consumed and less is
invested?
• Less investment today means less economic
growth in the future.
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EXHIBIT 5
GROSS NATIONAL SAVING IN THE UNITED
STATES: 1960–99
Source: Council of Economic Advisers, Economic Report of the President (Washington, D.C.: U.S. Government Printing Office, 2000), p. 73.
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Exhibit 5: Gross National Savings
in the United States: 1960-99
According to Exhibit 5, what is
the relationship between personal
savings and government savings?
• It appears that they may be inversely
proportional.
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EXHIBIT 6
SOURCES OF US. GROWTH: 1947–2003
Source: Council of Economic Advisers, Economic Report of the President (Washington, D.C.: U.S. Government Printing Office, 1994), p. 44, and
author’s estimates.
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Exhibit 6: Sources of U.S.
Growth: 1947-2003
1. According to Exhibit 6, which of the
following made the largest contribution
to economic growth from 1947 to 1973:
a. Labor inputs
b. Capital inputs
c. Technological change
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Exhibit 6: Sources of U.S.
Growth: 1947-2003
1. According to Exhibit 6, which of the
following made the largest contribution
to economic growth from 1947 to 1973:
a. Labor inputs
b. Capital inputs
c. Technological change
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Exhibit 5: Sources of U.S.
Growth: 1947-2003
2. According to Exhibit 6, which of
the following made the largest
contribution to economic growth
from 1973 to 1992:
a. Labor inputs
b. Capital inputs
c. Technological change
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Exhibit 6: Sources of U.S.
Growth: 1947-2003
2. According to Exhibit 6, which of
the following made the largest
contribution to economic growth
from 1973 to 1992:
a. Labor inputs
b. Capital inputs
c. Technological change
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Exhibit 6: Sources of U.S.
Growth: 1947-2003
3. According to Exhibit 6, what happened
to the role of technological change as a
source of U.S. economic growth across the
two time periods?
• While technological change was the most
important source of economic growth from 1947
to 1973, it was one of the smallest and least
important sources of economic growth
between 1973 and 1992.
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The Business Cycle
The business cycle represents
year to year deviations from the
dominant, long-run path of U.S.
economic growth. These
deviations seem to map out a
picture of recurring cycles.
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EXHIBIT 7 THE U.S. BUSINESS CYCLE RECORD:
1860–1990
Source: Ameritrust Company, Cleveland, Ohio.
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Exhibit 7: The U.S. Business
Cycle Record: 1860-1990
1. According to Exhibit 7, were
recessions more frequent before
World War II or after World War
II?
• Recessions were more frequent before
World War II.
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Exhibit 7: The U.S. Business
Cycle Record: 1860-1990
2. In which of the following
decades was there the greatest
period of rapid and prolonged
economic growth in Exhibit 6?
a. 1870 – 1880
b. 1930 – 1940
c. 1960 – 1970
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Exhibit 7: The U.S. Business
Cycle Record: 1860-1990
2. In which of the following
decades was there the greatest
period of rapid and prolonged
economic growth in Exhibit 6?
a. 1870 – 1880
b. 1930 – 1940
c. 1960 – 1970Gottheil - Principles of Economics, 4e
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Traditional Theories of the
Business Cycle
1. What factors contribute to
externally induced cycles?
• Wars, changes in climate, population
booms, clustering of innovations, changes
in consumer confidence, changes in
government spending, or changes in
international exchange rates.
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Traditional Theories of the
Business Cycle
2. What is the sunspot theory of
the business cycle?
• According to William Stanley Jevons,
years of good harvest, low food prices, and
higher real income and employment, are
inversely related to the number of
sunspots.
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Traditional Theories of the
Business Cycle
2. What is the sunspot theory of
the business cycle?
• The sunspot theory mostly applies to
agricultural economies, and is less relevant
to modern industrialized countries.
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Traditional Theories of the
Business Cycle
3. What is the war-induced theory
of the business cycle?
• Wars require massive increases in
government spending, which tends to
increase economic growth. Marxists and
others have argued that wars are
sometimes engineered to get us out of
economic crises.
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Traditional Theories of the
Business Cycle
3. What is the war-induced theory
of the business cycle?
• The decline in spending at the end of wars
can contribute to economic downturns.
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Traditional Theories of the
Business Cycle
4. What is the housing theory of
the business cycle?
• Disasters or low interest rates spur large
investments in new housing, which in turn
promotes increased economic growth. As
housing investment slows, so too does
economic growth.
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Traditional Theories of the
Business Cycle
5. What is the innovation theory
of the business cycle?
• Pioneering innovations promote a host of
supporting innovations in clusters, and
thus produce their own variety of business
cycle. Steam engines, railroads, electricity,
cars, and computers offer some examples.
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Traditional Theories of the
Business Cycle
5. What is the innovation theory
of the business cycle?
• Yet even pioneering innovations eventually
exhaust their potential, creating the potential
for reduced investment, demand, and
employment.
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Traditional Theories of the
Business Cycle
• Many economists believe that
business cycles do not just
develop from external factors.
• According to this view, the
economy’s continuous motion is
inherently cyclical due to internal
factors.
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Traditional Theories of the
Business Cycle
6. What factors contribute to
internally induced business
cycles?
• Changes in investment spending and
changes in national income are mutually
reinforcing due to the role of expectations.
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Traditional Theories of the
Business Cycle
Accelerator
• The relationship between the level of
investment and the change in the level of
national income.
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Traditional Theories of the
Business Cycle
7. How does the accelerator
contribute to the business cycle?
• An initial injection of new investment
spending into the economy triggers the
income multiplier into action, and as a
result people’s income and consumption
spending grow.
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Traditional Theories of the
Business Cycle
7. How does the accelerator
contribute to the business cycle?
• Buoyed by this growth in sales, firms expect
growth to continue and increase investment
spending accordingly. This creates the
upward phase of the business cycle.
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Traditional Theories of the
Business Cycle
7. How does the accelerator
contribute to the business cycle?
• Having acquired additional capital stock
through investment, firms must experience even
higher sales. But if consumers simply maintain
their level of consumption, inventories build up
and investment declines, initiating the downward
phase of the cycle.
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Real Business Cycle Theory
Economists who subscribe to real
business cycle theory challenge
the idea that internal or external
cycles exist.
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Real Business Cycle Theory
They argue that the economy is
dynamic and operates near full
employment. The principal factor
shaping the unevenness (not cycles)
in the economy’s growth path is
the random occurrence of many
small productivity-enhancing
innovations.
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Real Business Cycle Theory
How is real business cycle theory
different from the innovation cycle
theory developed by Schumpeter?
• The Schumpeterian innovation cycle is
based on the notion that innovations are
clustered and connected, leading to cycles.
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Real Business Cycle Theory
How is real business cycle theory
different from the innovation cycle
theory developed by Schumpeter?
• In contrast, real business cycle theory
assumes many small random innovations
that lead to an uneven path of economic
growth but no cycles.
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Countercyclical Fiscal Policy
Countercyclical fiscal policy
• Fiscal policy designed to moderate the
severity of the business cycle.
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Countercyclical Fiscal Policy
1. Which of the following is an
example of countercyclical fiscal
policy?
a. More government spending when the
economy is growing rapidly.
b. Higher taxes when the economy is
growing rapidly.
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Countercyclical Fiscal Policy
1. Which of the following is an
example of countercyclical fiscal
policy?
a. More government spending when the
economy is growing rapidly.
b. Higher taxes when the economy is
growing rapidly.
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Countercyclical Fiscal Policy
2. Why is timing such a difficult
problem with effective countercyclical fiscal policy?
• Long lags between the identification of the
economic problem and the execution of the
policy can unintentionally lead to procyclical
rather than countercyclical policy.
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Countercyclical Fiscal Policy
2. Why is timing such a difficult
problem with effective countercyclical fiscal policy?
• Thus countercyclical fiscal policy must be
based on forecasts of future economic
conditions, and these forecasts can be
wrong.
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Countercyclical Fiscal Policy
Administrative lag
• The time interval between deciding on an
appropriate policy and the execution of
that policy.
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EXHIBIT 8
DESIGNING COUNTERCYCLICAL POLICY
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Exhibit 8: Designing
Countercyclical Policy
If the economy follows path ac
instead of path ab, but countercyclical fiscal policy is designed for
path ab, what is might occur?
• The dynamics of the acceleratormultiplier interaction will drive the
economy into inflation.
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Countercyclical Fiscal Policy
There are many economic theories
of cycles and growth, some making
good sense, some less so, but all of
them struggling to understand the
real world.
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