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Economic Growth and
Rising Living Standards
© 2003 South-Western/Thomson Learning
The Importance of Growth
Achieving a higher rate of growth in
the long run generally requires some
sacrifice in the short run.
The Importance of Growth
Average Standard of Living
Total output (Real GDP) per
person
The Importance of Growth
• When output grows faster than the
population, GDP per capita - the
average standard of living - will rise.
• When output grows more slowly than
the population, the average standard
of living will fall.
What Makes
Economies Grow?
Economic growth is a long-run
phenomenon.
The classical model is particularly
well suited to analyze long-run
economic problems, including the
problem of growth.
What Makes Economies Grow?
• The classical model states that the
economy tends to operate at its fullemployment output level over the
long run.
• Economic growth depends upon
changes that would cause fullemployment output to increase.
What Makes
Economies Grow?
Three Most Important Causes:
•Increases in Employment
•Increases in the Capital Stock
•Changes in Technology
Growth in Employment
•How to Increase Employment
•Employment Growth and
Productivity
Growth in Employment
Growth in employment can arise from an
increase in labor supply (a rightward shift
in the labor supply curve) or an increase
in labor demand (a rightward shift of the
labor demand curve).
Increase in Labor Supply
At point A, labor supply and demand
determine an employment level of
100 million workers.
(a)
Real
Hourly
Wage
S
L1
S
L2
A
An increase in labor supply raises
employment to 120 million
(at point B) although with a lower
wage rate.
$15
B
12
D
L
100 120
Millions
of Workers
(b)
Real
Output
$8 trillion
$7 trillion
B
A
With more people working,
real GDP rises from $7 trillion
to $8 trillion.
100 120
Millions
of Workers
Increase in Labor Demand
(a)
Real
Hourly
Wage
S
L
If firms demand more labor,
employment will increase—from
100 million to 120 million–
while the wage rate rises.
B
$17
15
A
D
D
L2
L1
100 120
Millions
of Workers
(b)
Real
Output
$8 trillion
$7 trillion
A
B
With more people working,
real GDP increases from
$7 trillion to $8 trillion.
100 120
Millions of Workers
The U.S. Labor Market
Real
Hourly
Wage
S
L1
S
L2
B
W2
W1
A
D
L2
D
L1
L1
L2
Millions
of Workers
How to Increase Employment
• A cut in tax rates increases the reward for
working, while
• A cut in benefits to the needy increases
the hardship of not working.
–Either policy can cause a greater right-ward
shift in the economy’s labor supply curve than
would otherwise occur and would speed the
growth in employment and output.
How to Increase Employment
Government policies that help increase
the skills of the workforce or that
subsidize employment more directly shift
the economy’s labor demand curve to the
right, increasing employment and output.
Employment Growth and
Productivity
Labor Productivity
Total output (real GDP) per worker
output
vertical measure
Productivi ty 

employment horizontal measure
Employment and Labor
Productivity
Real
Output
Slope = Productivity
= $66,666
Slope = Productivity
= $70,000
$8 trillion
$7 trillion
A
100
B
120
Millions
of Workers
Employment Growth and
Productivity
When employment increases, while the
capital stock remains constant, the
amount of capital available to the average
worker will decrease, and labor
productivity will fall.
Growth of the Capital Stock
•Investment and the Capital Stock
•How to Increase Investment
•Human Capital and Economic Growth
Growth of the Capital Stock
An increase in the capital stock
causes labor productivity and living
standards to increase.
Growth of the Capital Stock
Real
Output
$8 trillion
$7 trillion
D
A
100
Millions
of Workers
Growth of the Capital Stock
Capital per Worker
The total capital stock divided by
total employment.
Growth of the Capital Stock
• If the capital stock grows faster than
employment, then capital per worker will
rise, and labor productivity will increase
along with it.
• But if the capital stock grows more slowly
than employment, then capital per worker
will fall, and labor productivity will fall as
well.
Investment and the Capital
Stock
As long as investment is greater
than depreciation, the total stock
of capital will rise.
How to Increase Investment
• Increasing the Incentive for
Businesses to Invest
• Increasing the Incentive for
Households to Save
• Shrinking the Government’s Budget
Targeting Business: Increasing the
Incentive to Invest
Corporate Profits Tax
A tax on the profits earned by corporations.
Investment Tax Credit
A reduction in taxes for firms that invest in
certain favored types of capital.
Increase in Investment Spending
Interest
Rate
Supply
of Funds
(Saving)
B
5%
A
C
3%
New Demand
for Funds
Original
Demand for Funds
1.5 1.75
2.25
Funds
($ Trillions)
Targeting Business: Increasing
the Incentive to Invest
Investment curve can shift rightward if
• business taxes are reduced, or
• there are specific investment incentives
This speeds growth in
• physical capital
• rate of living standard
Targeting Households:
Increasing the Incentive to Save
Capital Gains Tax
A tax on profits earned when a financial asset
is sold at more than its acquisition price.
Consumption Tax
A tax on the part of their income that
households spend.
Increase in Saving
Interest
Rate
5%
Original
Supply
of Funds
B
New Supply
of Funds
F
C
3%
Investment
Spending
1.75
2.25 2.5
Funds($ Trillions)
Targeting Households:
Increasing the Incentive to Save
Government can alter the tax and transfer
system to increase incentives for saving.
If successful, these policies would
• make more funds available for investment,
• speed growth in the capital stock, and
• speed the rise in living standards.
Shrinking the Government’s
Budget
A shrinking deficit or a rising surplus
tends to reduce interest rates and
increase investment, thus speeding
the growth in the capital stock.
The Government Budget
Government investment in new
capital and in the maintenance of
existing capital makes an important
contribution to economic growth.
Deficit Reduction and
Investment Spending
(a)
Price
per
Bushel
(b)
Dollars
S1
MC
With initial
supply curve
S1, market
price is $4.50 . . .
A
$4.50
A
$4.50
ATC
d1
. . . so each
firm earns an
economic profit
D
5,000
Bushels
per Year
900,000
(c)
(d)
Dollars
Price
per
Bushel
S1
. . . until market
price falls to $2.50
and each firm earns
zero economic profit
Profit attracts
entry, shifting the
supply curve
rightward . . .
MC
S2
$4.50
Bushels
per Year
9,000
A
$4.50
E
2.50
A
2.50
ATC
d1
d2
E
D
900,000
1,200,000 Bushels
per Year
5,000
9,000
Bushels
per Year
The Government’s Budget
• The impact of deficit reduction on
economic growth depends on which
government programs are cut.
• Shrinking the deficit by cutting
government investment will not stimulate
growth as much as would cutting other
types of government spending.
Human Capital and
Economic Growth
Human Capital
Skills and knowledge possessed
by workers
Human Capital and Economic
Growth
Increase in human capital works like
increase in physical capital to increase
output:
• Causes the production function to shift
upward,
• Raises productivity, and
• Increases the average standard of living.
Technological Change
Technological Change
The invention or discovery of new
inputs, new outputs, or new
production methods.
Technological Change
The faster the rate of technological
change, the greater the growth rate
of productivity, and the faster the rise
in living standards.
Technological Change
• The rate of technological change in
the economy depends largely on
firms’ total spending on R&D.
• Policies that increase R&D spending
will increase the pace of
technological change.
Technological Change
Patent Protection
A government grant of exclusive
rights to use or sell a new technology
The Cost of Economic Growth
Promoting economic growth involves
unavoidable trade-offs:
• It requires some groups, or the nation as a
whole, to give up something else that is
valued.
• In order to decide how fast we want our
economy to grow, we must consider
growth’s costs as well as its benefits.
The Cost of Economic
Growth
• Budgetary Costs
• Consumption Costs
• Opportunity Costs of Workers’
Time
• Sacrifice of Other Social Goals
Budgetary Costs
Properly targeted tax cuts can
increase the rate of economic growth,
but will force us to either redistribute
the tax burden or cut government
programs.
Consumption Costs
Greater investment in physical
capital, human capital, or R&D will
lead to faster economic growth and
higher living standards in the future,
but we will have fewer consumer
goods to enjoy in the present.
Consumption, Investment, and
Economic Growth
Production
of Capital
Goods
D
K
E
B
A
C
Production
of Consumption
Goods
Opportunity Costs of
Workers’ Time
An increase in the fraction of the
population with jobs or a rise in working
hours will increase output and raise
living standards, but also requires us to
sacrifice time previously spent in
nonmarket activities.
Sacrifice of Other
Social Goals
We can achieve greater worker
safety, a cleaner environment, and
other social goals, but we may have
to sacrifice some economic growth
along the way.
Sacrifice of Other
Social Goals
Alternatively, we can achieve greater
economic growth, but we will have
to compromise on other things we
care about.
Economic Growth in LessDeveloped Countries
Reasons for low-growth rates of many
LDCs:
• Very low current output per capita
• High population growth rates
• Poor infrastructure
Economic Growth in LessDeveloped Countries
Production
of Capital
Goods K
J
H
N
R
S
C
Production
of Consumption
Goods
Economic Growth in LessDeveloped Countries
• Poorest LDCs are too poor to take
advantage of the trade-off between
consumption and capital production in
order to increase their living standards.
• They cannot reduce consumption, so
cannot produce enough capital to keep
up with their rising population.
Growth Options for LessDeveloped Countries
(b)
(a)
Production
of Capital
Goods
K
Production
of Capital
Goods
K
F
H
N
T
N
N’
S
C
Production
of Consumption
Goods
S
C
Production
of Consumption
Goods