Why Do Economies Grow?

1. Why Do Economies Grow?

2. Why Do Economies Grow? • Economists believe that there are two basic mechanisms that increase GDP per capita over the long term: • Capital deepening: an increase in the economy’s stock of capital—plant and equipment—relative to its workforce. • Technological progress: the ability to produce more output without using any more inputs—capital or labor. • The role of education and investment in human beings in fostering economic development is called human capital.

3. Economic Growth Rates • A meaningful measure of the standard of living in a given country is real GDP per capita, or real GDP per person. • Real GDP per capita typically grows over time. The growth rate of a variable is the percentage change in that variable from one period to another.

4. Measuring Economic Growth • At 4% for the next ten years, GDP will be: • If the economy started at 100 and grew at a rate g for n years, then real GDP after n years equals:

5. Measuring Economic Growth • To find out how many years it would take for GDP to double, we use the rule of 70: If an economy grows at x percent per year, output will double in 70/x years.

6. Comparing the Growth Ratesof Various Countries

7. Are Poor Countries Catching Up? • Economists question whether poorer countries can close the gap between their level of GDP per capita and that of richer countries. • The process by which poorer countries catch up with richer countries in terms of real GDP per capita is called convergence. • To converge, poor countries have to grow at more rapid rates than richer countries are growing. • In the last twenty years, there has been little convergence.

8. Countries with Lower Incomein 1870 Grew Faster • The relationship between growth rates and per capita income in 1870 is downward-sloping. • Countries with higher levels of GDP in 1870 grew more slowly than countries with lower levels of GDP.

9. Capital Deepening • One of the most important mechanisms of economic growth economists have identified is increases in the amount of capital per worker due to capital deepening.

10. Capital Deepening • An increase in capital means more output can be produced. • Firms will increase their demand for labor and, as they compete for a fixed labor supply, real wages will rise.

11. Capital Deepening • How does an economy increase its stock of capital? • The economy must increase its net investment. • To increase net investment, gross investment must also rise. • The amount of income available for investment comes from saving.

12. Saving and Investment • Total income minus consumption is saving. By definition, consumption plus saving equals income: • At the same time, income—which is equivalent to output—also equals consumption plus investment: • Thus, saving must equal investment: • C + S = Y • C + I = Y • S = I

13. Saving and Investment • This means, whatever consumers decide to save goes directly into investment. • It follows that in order for the stock of capital to increase, gross investment must exceed depreciation. • The stock of capital increases with any gross investment spending but decreases with any depreciation. • However, as capital grows, depreciation also grows, eventually catching up to the level of gross investment, and putting a stop to the growth of capital deepening.

14. How Does Population GrowthAffect Capital Deepening? • Population growth, which increases the size of the labor force, will cause the capital per worker ratio to decrease. • With less capital per worker, output per worker will also tend to be less because each worker has fewer machines to use. This is an illustration of the principle of diminishing returns. PRINCIPLE of Diminishing ReturnsSuppose output is produced with two or more inputs and we increase one input while holding the other input or inputs fixed. Beyond some point—called the point of diminishing returns—output will increase at a decreasing rate.

15. How Does the GovernmentAffect Capital Deepening? • The government can affect the process of capital deepening in several ways: • Higher taxes will reduce total income. Assuming that households save a fixed fraction of their income, an increase in taxes will cause savings to fall. • As the government drains savings from the private sector, the amount of total investment decreases, and there is less capital deepening. • This occurs when the government uses the taxes collected from the private sector to engage in consumption spending, not investment. However, if the government taxes the private sector in order to increase investment, then it will be promoting capital deepening.

16. How Does Trade Affect Capital Deepening? • The foreign sector can also affect capital deepening. • An economy can run a trade deficit and import investment goods to aid capital deepening. It can finance the purchase of those goods by borrowing and, as investment raises, GDP and economic wealth rises and the country can afford to pay back the borrowed funds. • Trade deficits that fund current consumption do not aid in the process of capital deepening.

17. Limits to Capital Deepening • There is a limit to growth through capital deepening because even though at higher rate of saving can increase the level of real GDP, eventually the process comes to a halt. • However, it takes time—decades—for this point to be reached. Capital deepening can be an important source of economic growth for a long time.

18. The Key Role ofTechnological Progress • Technological progress is the ability of an economy to produce more output without using any more inputs. • With higher output per person, we enjoy a higher standard of living. • Technological progress, or the birth of new ideas, is what makes us more productive. Per capita output will rise when we discover new and more effective uses of capital and labor.

19. How Do We MeasureTechnological Progress? • Robert Solow, a Nobel laureate in economics from MIT, developed a method for determining the contributions to economic growth from increased capital, labor, and technological progress, called growth accounting. • Increases in A represent technological progress, or more output produced from the same level of inputs, K and L. • We can measure technological progress indirectly by observing increases in capital, labor, and output. • Y = F(K,L,A)

20. How Do We MeasureTechnological Progress? • Total output grew at a rate of nearly 3%. Because capital and labor growth are measured at 0.56% and 1.34%, respectively, the remaining portion of output growth, 1.02%, must be due to technological progress. That means that approximately 35% of output growth came directly from technological progress.

21. Examples of Growth Accounting • From 1980 to 1985, the economies of Hong Kong and Singapore both grew at impressive rates of about 6%, yet the causes and results of growth in each country were very different. • Singapore’s growth was attributed to increases in labor and capital, while in Hong Kong technological progress was the key to growth. • Residents of Hong Kong could enjoy the same level of GDP but consume, not save, a higher fraction of their GDP.

22. What Caused LowerU.S. Labor Productivity? • Labor productivity is defined as output per hour of work for the economy as a whole. • Labor productivity measures how much a typical worker can produce with the current amount of capital and given the state of technological progress. • A significant slow-down in productivity in the United States since 1973 meant slow growth in real wages and in GDP. • In recent years, there has been a resurgence in productivity growth, which reached 2.5% from 1994-2000.

23. What Caused LowerU.S. Labor Productivity? • The period of slower labor productivity growth cannot be explained by reduced rates of capital deepening, nor by changes in the quality of the labor force. • A slowdown in technological progress and higher energy prices have been linked by some economists to the slowdown in productivity.

24. Real Hourly Earnings and Total Compensation in the United States • The slowdown in productivity growth also meant slower growth in real wages and in GDP since 1973. • Total compensation did continue to rise through the 1980s and 1990s.

25. How Have the Internet and Information Technology Affected GDP? • “New economy” proponents believe the computer and Internet revolution are responsible for the increase in productivity growth in the last half of the 1990s. • Productivity growth continued to be rapid, even during the recessionary period at the beginning of this century, when most economists believed it would slow down.

26. What Causes Technological Progress? • Research and development in science. • Government or large firms who employ workers and scientists to advance physics, chemistry, and biology are engaged in technological progress in the long run. • The United States has the highest percentage of scientists and engineers in the labor force in the world. • Not all technological progress is “high tech.”

27. Research and DevelopmentFunding as a Percent of GDP, 1999

28. What Causes Technological Progress? • Monopolies that spur innovation (Joseph Schumpeter). • The process by which competition for monopoly profits leads to technological progress is called creative destruction by Schumpeter. • By allowing firms to compete to be monopolies, society benefits from increased innovation.

29. What Causes Technological Progress? • The scale of the market. • Adam Smith stressed the importance of the size of a market for economic development. • There are more incentives for firms to come up with new products and methods of production in larger markets.

30. What Causes Technological Progress? • Induced innovations. • Some economists emphasize that innovations come about through inventive activity designed specifically to reduce costs. • Education and the accumulation of knowledge. • Modern theories of growth that try to explain the origins of technological progress are know as new growth theory.

31. A Key Governmental Role:Getting the Incentives Right • Governments must design institutions in a society in which individuals and firms work, save, and invest. • One of the basic laws of economics is that individuals and firms respond to incentives. • Policies that tax exports, lead to rampant inflation, or inhibit the growth of the banking and financial sectors, can cripple the economy’s growth prospects.

32. Human Capital • Human capital is an investment in human beings—in their knowledge, skills and health. • In terms of understanding economic growth, human capital investment has two implications: • Not all labor is equal. Individuals with more education will, on average, be more productive. • Health and fitness affect productivity. If workers are frail and ill, they can’t contribute much to national output.

33. New Growth Theory • The work of economists that developed models of growth that contained technological progress as essential features came to be known as new growth theory, which accounts for technological progress within a model of growth. • Economists in this field study how incentives for research and development, new product development, or international trade interact with the accumulation of physical capital.

34. Appendix:A Model of Capital Deepening • The Solow model shows that: • Capital deepening, the increase in the stock of capital per worker, will occur as long as total saving exceeds depreciation. Capital deepening results in economic growth and increased real wages. • Eventually, the process of capital deepening will come to a halt as depreciation catches up with total saving.

35. Appendix:A Model of Capital Deepening • A higher saving rate will promote capital deepening. • If a country saves more, it will have a higher output (until the process of economic growth through capital deepening ends). • Technological progress not only causes output to increase but also allows capital deepening to continue.

36. Diminishing Returns to Capital • The relationship between output and the stock of capital, holding the labor force constant, shows that as the stock of capital increases, output increases at a decreasing rate. PRINCIPLE of Diminishing ReturnsSuppose output is produced with two or more inputs and we increase one input while holding the other input or inputs fixed. Beyond some point—called the point of diminishing returns—output will increase at a decreasing rate.

37. Appendix:A Model of Capital Deepening • Output increases with the stock of capital, and the stock of capital increases as long as gross investment exceeds depreciation. • In the absence of government or the foreign sector, private-sector saving equals gross investment. • In order to determine the level of investment, we need to find out how much of output is saved and how much is consumed.

38. Saving and Depreciation as Functions of the Stock of Capital • Essential relationships in the Solow model include output (Y) as a function of the stock of capital (K), and saving as a function of the stock of capital (sY). • Also, total depreciation as a function of the stock of capital (dK), where d is the depreciation rate per year, which is constant and proportional to the stock of capital (K).

39. Basic Growth Model • At K0, sY > dK then K will rise. Change in the stock of capital= sY – dK • At K1, sY > dK then K continues to rise. • At K*, sY = dK then K no longer increases. • As long as total saving exceeds depreciation, economic growth, through capital deepening, will continue. The process continues until the stock of capital reaches its long-run equilibrium K*.

40. Increase in the Saving Rate • A higher saving rate will lead to a higher stock of capital in the long run. • Starting from an initial capital stock of K1, the increase in the saving rate leads the economy to K2.

41. Technological Progress and Growth • Technological progress shifts up the saving schedule and promotes capital deepening.

42. Key Terms capital deepening convergence creative destruction growth accounting growth rate human capital labor productivity new growth theory real GDP per capita rule of 70 saving technological progress