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ECONOMICS:
EXPLORE & APPLY
by Ayers and Collinge
Chapter 12
“Economic Growth”
©2004 Prentice Hall Publishing
Ayers/Collinge, 1/e
1
Learning Objectives
1. Identify the sources of economic
growth.
2. Describe the role of savings and
investment in the process of capital
formation.
3. Analyze how taxation affects both
savings and investment activity.
4. Provide justification for subsidized
higher education.
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Learning Objectives
5. Summarize new growth theory and supply
side economics
6. Discuss the key role of labor productivity in
economic growth.
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12.1
THE SEEDS OF ECONOMICS GROWTH
• Economic growth is measured by the
change in real GDP over time.
– Sometimes a GNP measure is used instead.
• Economies turn resources into outputs of
greater value.
– Over time the possibilities for doing so
expand as the economy develops new
technologies, and acquires new resources.
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Sources of Economic Growth
o Most U.S. economic growth is
attributable to increases in labor and
capital.
o Both technological change and additional
capital increase labor productivity.
o Increases in labor productivity means
that more GDP is produced for each hour
worked by by the labor force.
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Annualized Growth Rates by
Presidency
PRESIDENCY
YEARS
GROWTH
RATE
Kennedy-Johnson
1961-1968
4.9
Nixon-Ford
1969-1976
3.0
Carter
1977-1980
2.7
Reagan
1981-1988
3.5
Bush 1
1989-1992
1.7
Clinton
1993-1999
3.7
Bush 2
2001-2002(1)
2.5
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Sources of Economic Growth
 The growth rate increases in some years,
decreases in some years, and even falls in other
years because of economic slowdowns.
 When recession begins, labor productivity
tends to fall as aggregate demand and
production decrease.
 When recession nears it end, production at first
increases, with no corresponding increase in
employment, causing productivity to rise.
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Sources of Economic Growth
Labor productivity is associated with the
amount of capital – both physical and human –
labor has at its disposal.
The creation and accumulation of new capital
is termed capital formation.
Capital formation requires initiative, and in
market economies entrepreneurs make these
choices based on profitability judgments.
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Nurturing Growth –
Savings and Investment
Capital formation requires investment, which
can be coordinated centrally through
government.
Investment can also be a decentralized process
that responds to supply and demand in the
marketplace.
Investors finance the capital formation that is
necessary to take advantage of market
opportunities.
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Nurturing Growth –
Savings and Investment
Firms invest when they
wish to do any of the
following:
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 Expand their scale of
operations.
 Implement better
production techniques.
 Produce new goods that
their old factories are illsuited to manufacture.
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Nurturing Growth –
Savings and Investment
 To acquire human capital, individuals invest in
themselves.
 Savings provides the capital for investment.
 Government reduces private savings and
investment in two ways.
 It taxes away income that might be saved.
 It taxes the return on investments.
 In contrast, government also adds to
investment.
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Nurturing Growth –
Savings and Investment
Without government, aggregate savings and investment
would be the same. With government the situation is
more complex because tax dollars can be directed towards
government investment or government consumption.
Investment + Government consumption = Savings + Taxation
or, equivalently,
Investment = Savings + Taxation - Government consumption
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Nurturing Growth –
Savings and Investment
• Higher interest rates raise the cost of
investing.
• A crowding out effect occurs when
government borrowing is in competition
with private-sector borrowing, and thus
can cause higher interest rates.
• Higher interest rates decrease
investment.
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Nurturing Growth –
Savings and Investment
 Investment is also
affected by the
following factors..
 Business confidence
 Current economic
growth
 Opportunities
presented by
technological change
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 Increases in any of
these variables would
shift the investment
demand curve to the
right.
 Decreases would shift
the investment
demand curve to the
left.
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The Equilibrium Interest Rate
Real
Interest
Rate
As the interest rate
gets lower, businesses
borrow more…
Supply of
savings
…and people
save less.
At equilibrium, the
amount borrowed
and saved is equal.
Actual
Interest
Rate
Actual savings
and investment
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Demand for
investment
Savings and
investments
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12.2
INFLUENCING GROWTH THROUGH
PUBLIC POLICY
Private investors assess the expected return,
which is the value of the investment if
successful, multiplied by the probability of
success.
The actual return can be viewed as ex post,
meaning after the fact.
Ex post, an investment might have turned out
fabulously, or might have failed miserably.
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The Incentive Effects of Taxation
In addition to regulation, taxes can also
affect growth.
A tax on savings increases the market
interest rate and discourages investment.
Taxing the return to savings shifts the
supply of savings to the left.
There is concern over the low personal
savings rate in the U.S. in recent years.
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The Incentive Effects of Taxation
Investment is also discouraged by other
taxes such as the tax on capital gains.
Capital gains represents the difference
between the current market value of an
investment and its purchase price.
The capital gains tax takes a percentage
of this difference when the investment is
sold.
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Effects of the Income Tax
Supply of savings
Real
Interest
Rate
Supply of savings
A tax on savings
changes the market
equilibrium for savings
and investment.
Higher
interest
rate
Demand for
investment
Lower savings
and investment
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Savings and
investment
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Subsidizing Research and
Development
 An external benefit occurs when some benefits
are received by third parties who are not
directly involved in a decision, such as the
decision to research or invest.
 Research is aimed at creating new products or
otherwise expands the frontiers of knowledge
and technology.
 Development occurs when that technology is
embodied into capital or output.
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Subsidizing Research and
Development
 External benefits are most prominent at the
research stage.
 Especially when the research involves the creation
of knowledge that can be applied to the
production of many different products.
 It is difficult for any one investor or group of
investors to assert property rights over the range
of applications that can arise from basic advances
in knowledge.
 To correct this market failure the government
subsidizes research.
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Subsidizing Research and
Development
Universities are often the source
of valuable research, subsidized
by government that companies
fear to undertake on their own.
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12.3
PROPERTY RIGHTS AND NEW GROWTH
THEORY
 The prospect for business profits in the future
can lead to research and development in the
present.
 This idea is the cornerstone for what is called
the new growth theory, which emphasizes the
importance of new ideas in generating
economic growth, and intellectual property
rights in providing the profit incentive to
generate those ideas.
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12.4
SUPPLY-SIDE POLICY
• Those economist who particularly emphasize
policy aimed at growth are called supply-side
economist, or supply-siders for short.
• Supply-siders focus on increasing the value of what
the economy can produce in the long-run (the
supply side) rather than on any desire to change
consumer’s spending behavior (the demand side).
• Supply-siders feel that the short-run business cycle
will sort itself out over time as long as the
government does not intrude.
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Supply-Side Policy
 The objective of supply-side policy is to ensure that
output associated with full employment is as high as
possible.
 Supply-side policies are designed to increase
productivity, such as through increasing capital
formation.
 Full-employment output will change in response to
changes in structural features of the economy,
including resources and technology.
 Structural features also include government policies
that change how workers and firms behave.
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Supply-Side Policy
Critics refer to supply-side policies as
trickle down economics. The term suggest
that the policies were intended to make the
rich richer, so that they might spend a bit more
and help the rest of us. This is not the process
intended by supply-siders, instead they aim at
increasing productivity, not spending.
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Supply-Side Policy
Long-run
Aggregate supply
Price level
Supply siders aim to
get more output from
full employment
Full-employment output
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Real GDP
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The Laffer Curve
Increasing tax rates will increase tax
revenues, but only up to a point.
After that point, higher tax rates are selfdefeating and actually reduce tax
revenues.
At a rate of 100 percent, there would be
no point to earning any income at all.
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The Laffer Curve
Tax
Revenue
Maximum Tax Revenue
0%
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Tax rate
100%
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How Technology Impacts Growth
 The ‘new’ U.S. economy is characterized by the
application of technology to increase business
productivity.
 The growth of computers in the workplace
increases the productivity of labor.
 Throughout history, the economy has been
revitalized again and again by technologies like
the railroad, the automobile, radio, television,
and now the computer and the Internet.
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Sources of Changes in United States
Labor Productivity 1979-2000
Item
1970 to 1990
1990 to 1995
1995 to 2000
(1) Output per hour
(labor productivity)
1.6
1.5
2.7
(2) Contribution of
capital
0.8
0.5
1.1
(2a)Contribution of
information technology
capital
0.5
0.4
0.9
(2b) Contribution of
other capital
0.3
0.1
0.2
(3) Contribution of labor
0.3
0.4
0.3
(4) Contribution of
technological change and
other factors
0.5
0.6
1.4
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12.5 EXPLORE & APPLY
The New Economy – Is It Real?
In the 1990’s the “new economy” was
characterized by the tremendous wealth
creation in the Silicon Valley.
The new economy is characterized by the
application of technology to increase
business productivity.
The application of computer technology
has been especially significant.
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Terms Along the Way







economic growth
labor productivity
capital formation
crowding-out effect
expected return
actual return
capital gains
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






capital gains tax
external benefit
research
development
property rights
new-growth theory
supply-side
economists
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Test Yourself
1.
a.
b.
c.
d.
Technological change and additional capital
increase labor productivity.
decrease labor productivity.
have no effect on labor productivity.
affect labor productivity in unpredictable
ways.
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Test Yourself
U.S. economic growth
a. has generally been characterized by a 5 percent
or more growth rate since the 1960’s.
b. varied with each president.
c. was on a downward trend in the 1990’s, but
has recently reversed its course.
d. is no longer considered an important goal.
2.
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Test Yourself
3.
a.
b.
c.
d.
Capital formation is also referred to as
property rights.
technology .
the real interest rate.
investment.
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Test Yourself
4.
a.
b.
c.
Investment equals
savings + taxation.
savings + taxation.
savings + taxation + government
consumption.
d. savings + taxation – government
consumption.
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Test Yourself
5.
a.
b.
c.
Higher real interest rates
increase the amount of investment.
decrease the amount of investment.
have no effect on the amount of
investment.
d. have varying and unpredictable effects
on investment.
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Test Yourself
6. The Laffer curve shows that the effect
of increasing taxes too much is
a. less economic growth.
b. less tax revenue.
c. more unemployment.
d. that only the rich get richer.
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The End!
Next Chapter 13
“Money, Banking,
and the Federal
Reserve"
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