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C h a p t e r
09
ECONOMIC GROWTH
O u t l i n e
Transforming People’s Lives
A. In the United States, real GDP per person doubled between 1961 and
2001. What causes the growth in production, income, and living
standards?
B. Elsewhere, notably in China and other parts of Asia, growth is even
faster; technology 2,000 years old coexists with the most modern. Why
is Asian growth so fast?
I.
Long-Term Growth Trends
A. Growth in the U.S. Economy
1. From 1901 to 2001, growth in real GDP per person in the United
States averaged 2.1 percent per year. Figure 24.1 (page 548/202)
illustrates.
2. Real GDP per person fell precipitously during the Great Depression
and rose rapidly during World War II.
B. Real GDP Growth in the World Economy
1. Some developed nations have grown more rapidly than the United
States. Until the 1990s, Japan grew fastest of the rich economies.
Figure 24.2(a) (page 549/203) illustrates.
2. Many less-developed countries in Africa, Central America, and South
America stagnated during the 1980s, and have grown slowly since;
they have fallen farther behind the United States. Figure 24.2(b)
(page 547/203) illustrates.
3. Other formerly less-developed nations — Hong Kong, Korea,
Singapore, and Taiwan are examples —have grown very rapidly and
have caught up or are catching up with the United States. Many
other Asian nations have faster growth than the United States.
Figure 24.3 (page 550/204) illustrates.
II. The Causes of Economic Growth: A First Look
A. Preconditions for Economic Growth
1. The basic precondition for economic growth is an appropriate
incentive system.
2. Three institutions are crucial to creation of the proper
incentives:
a) Markets. They enable buyers and sellers to transact and gather
information.
b) Property rights. From the book, “Property rights are the social
arrangements that govern the ownership, use, and disposal of
resources and goods and services.”
c) Monetary exchange. It lowers the costs of buying and selling.
3. Continuing growth requires incentives that encourage people to
pursue saving and investment in new capital, investment in human
capital, and discovery of new technologies.
B. Saving and Investment in New Capital
The accumulation of capital has dramatically increased output and
productivity.
C. Investment in Human Capital
1. Human capital includes people’s skills.
2. Much human capital is acquired through education; some human
capital is acquired through learning-by-doing.
D. Discovery of New Technologies
Technological advances have contributed immensely to increasing
productivity.
III. Growth Accounting
A. The quantity of real GDP supplied depends on the quantity of labor,
the quantity of capital, and the state of technology.
1. Growth accounting calculates how much real GDP growth has been due
to growth in labor, capital, and technology.
2. A key to growth accounting is the aggregate production function, Y =
F(L, K, T ), where Y is GDP, L is labor, K is the capital stock,
and T is technology.
B. Labor Productivity
1. Labor productivity is real GDP per hour of labor; it equals real GDP
divided by aggregate hours.
2. U.S. productivity growth slowed between 1973 and 1983, but then
speeded up again in the 1990s. Figure 24.4 (page 553/207) shows
U.S. productivity over the 1961 to 2001 period.
3. Growth accounting divides growth in productivity into two
components, growth in capital per hour of labor and technological
change.
4. Any productivity growth not accounted for by growth in capital is
allocated to technological change.
C. The Productivity Curve
1. The productivity curve is the relationship between real GDP per hour
of labor and the amount of capital per hour of labor, with
technology held constant. Figure 24.5 (page 554/208) represents a
productivity function.
a) An increase in capital per hour, say, from 30 to 60, causes a
movement along productivity function PC0 and increases output
per hour from 20 to 25.
b) Technological change shifts the productivity function; an
increase in technology shifts the productivity function upward
from PC0 to PC1, and could shift output per hour from 25 to 32
at 60 units of capital per hour of labor, or from 20 to 25 at 30
units of capital per hour of labor.
2. The law of diminishing returns states that, as the quantity of one input
increases, with all other inputs held constant, output increases
but eventually by increasingly smaller amounts. This accounts for
the convex shape of the curve.
3. The one-third rule is a useful rule of thumb for U.S. growth
accounting. It holds that a 1 percent increase in capital per hour
of work, with no change in technology, causes approximately a 0.33
percent increase in output per hour of labor.
D. Accounting for the Productivity Growth Slowdown and Speedup
1. The productivity function and one-third rule can be used to study
productivity growth in the United States. Figure24.6 (page 555/209)
illustrates.
2. From 1961 to 1973 the 32 percent increase in productivity was
caused by rapid technological change (which accounted for
productivity growth of 26 percent) and increased capital per worker
(which accounted for productivity growth of 6 percent).
3. From 1973 to 1983 productivity increased by 14 percent, of which
about 6 percent was caused by increased capital per worker and only
8 percent because of technological change. So productivity growth
slowed because technological change slowed.
4
From 1983 to 2001 productivity increased by 21 percent. Increased
capital per worker accounted for around 2.3 percent of the
increase, and technological change accounted for the remaining 18.7
percent, so productivity growth increased but did not reach the
rates of the 1960s.
E. Technological Change During the Production Growth Slowdown
1. Technological change did not contribute much to advancing
productivity during the 1970s for two reasons:
a) Energy price shocks drastically raised the price of energy,
which motivated technological innovation to produce goods and
services with less energy. Innovation was devoted to saving
energy rather than to increasing productivity.
b) Environmental protection laws were passed. Pollution abating
investment raised the quality of life but did not increase
(measured) GDP, so (measured) productivity did not increase.
F. Achieving Faster Growth
1. Growth accounting shows that to attain faster economic growth
requires increasing the growth rate of capital per hour of work or
increasing the growth rate of technological advance.
2.. Five policies can be advanced to speed economic growth:
a) Stimulate saving. Higher saving rates may increase the growth
rate of capital. Tax incentives might be provided to boost
saving.
b) Stimulate research and development. Because new discoveries can
be used by everyone, not all the benefit of a discovery falls to
the initial discoverer. So there is a tendency to under invest
in research and development activity. Government subsidies might
offset some of the underinvestment.
c) Target high-technology firms. The ones that should be subsidized
are high-technology industries in which the nation can enjoy a
temporary advantage over its competitors. This is a very risky
strategy, because it is unclear that government is better at
picking winners than the investment community.
d) Encourage international trade. The smaller restrictions on
international trade, the fewer the potential gains from
specialization and exchange that are not realized, and the
faster new technologies developed elsewhere can be implemented.
e) Improve the quality of education. Education is similar to basic
research insofar as benefits from education spread beyond the
person being educated so there is a tendency to underinvest in
education.
IV. Growth Theories
A. Classical Growth Theory
1. Classical economists lived in a time and place where population
growth was unprecedentedly rapid [it has been faster since] and
income per person had started to rise.
2. Classical growth theory is based on the idea that income per person
determines the rate of population growth.
3. Advances in technology increase labor productivity and the demand
for labor increases.
4. The increase in the demand for labor raises the real wage rate.
5. The rise in the real wage rate boosts the population growth rate,
which then increases the supply of labor.
6. The increase in the supply of labor lowers the real wage rate.
7. The supply of labor continues to increase until the real wage rate
has been driven back to the subsistence real wage rate, or the minimum
real wage rate necessary to sustain life. At this real wage rate,
both population growth and economic growth stop. Figure 24.7 (page
558/212) illustrates in terms of the productivity curve.
8. Contrary to the assumption of the classical theory, the historical
evidence shows that population growth rate is not a simple function
of income, and population does not always grow sufficiently to
drive average incomes back down to subsistence levels.
B. Neoclassical Growth Theory
1. Neoclassical growth theory was developed in the 1950s, when
technology was advancing and economic growth occurring.
2. Neoclassical growth theory suggests that real GDP per person grows
because technological change increases saving and investment.
3. The precursor to neoclassical growth theory was better economic
understanding of demographic forces, that is economic influences on
birth and death rates.
a) A key determinant of birth rates is the opportunity cost of
women’s time; higher incomes and modern living conditions raise
the cost of having children.
b) Higher incomes also greatly lower infant and child mortality.
c) These two forces tend to offset each other, and neoclassical
growth theory assumes that the population growth rate is
independent of the economic growth rate.
4. Technological change is the result of chance (luck) in the
neoclassical theory.
5. An increase in technology raises the profit from investment, so
investment increases. The increase in investment demand raises the
real interest rate and also increases the equilibrium quantity of
investment.
6. The faster the capital stock grows, the more rapid is economic
growth per person.
a) The demand for the stock of capital depends negatively on the
real interest rate.
b) The short-run supply of capital is fixed at whatever amount of
capital exists, though added saving (and investment) adds to the
stock of capital.
7. The technological advance increases the demand for capital and the
added investment adds to the capital stock.
8. When the real interest rate exceeds people’s target interest rate,
investment continues to add new capital, which lowers the real
interest rate.
9. Economic growth continues as long as technological change keeps the
real interest rate above the target interest rate.
10. When the capital stock has increased sufficiently to drive the
interest rate back to its target level, growth stops and only
enough investment is made to replace depreciated capital.
11. Figure 24.8 (page 560/214) illustrates neoclassical growth in
terms of the productivity curve.
12. A drawback to the neoclassical theory is that it predicts that all
countries converge to the same level of GDP per person.
C. New Growth Theory
1. The new growth theory emphasizes the role of technological change,
stresses that the rate of technological change depends on people’s
choices, and holds that the ability to replicate activities is the
key to economic growth.
2. Four aspects of discoveries of new technology are important:
a) Discoveries result from people’s choices.
b) Discoveries give the discoverer the opportunity to temporarily
earn large economic profits, but competition destroys those
profits.
c) Discoveries of new technology can be used by many people at the
same time, that is they are a public capital good.
d) Knowledge itself is not subject to diminishing returns, and
physical activities (firms) can be replicated throughout the
economy.
3. The fact that physical activities can be replicated is key. It
means that for the economy as a whole, the return from capital does
not diminish as more capital is acquired, so long as knowledge and
human capital continue to advance and add to productivity. The
capital demand curve is horizontal.
4. As long as the return from capital exceeds the target interest
rate, more capital is acquired and economic growth persists.
Because the capital demand curve is horizontal, the real interest
rate does not fall and so it remains perpetually above the target
interest rate. Capital constantly increases and economic growth is
perpetual. Figure 24.9 (page 562/216) illustrates in terms of the
productivity curve. Figure 24.10 (page 563/217) represents the
implied perpetual motion as a circular flow chart.