Economic Growth
Economic growth is growth of the standard of living
as measured by per person real GDP.
Our purpose in this chapter is to explain what
determines growth of potential GDP.
This will help us to understand why some nations or
regions have experienced rapid economic growth and
attained high living standards while others have
stagnated at low levels of real income.
Measurement of economic growth
Growth rate of
=
real GDP
Real GDP in
current year
_
Real GDP in
previous year
__________________________________
Real GDP in
previous year
X 100%.
For example, consider the following data for a
hypothetical economy:
Year
Real GDP
Population
Real GDP
per person
2005
$8.88 trillion
272.9 million
$32,539
2006
$9.32 trillion
275.4 million
$33,842
Using the data from the table, the growth rate of real
GDP from 2005 to 2006 is:
Growth rate of
=
real GDP
=
Real GDP in
current year
_
Real GDP in
previous year
__________________________________
Real GDP in
previous year
_
$8.88 trillion
__________________________________
≈ 5%.
$9.32 trillion
$8.88 trillion
X 100%
X 100%
Growth of the standard of living, however, is
measured by growth of real GDP per person.
There are two ways to calculate growth of real GDP
per person.
The first method is to divide real GDP by population
for each year, as done in column 4 of the table.
Then,
Growth rate of
real GDP per =
person
=
Real GDP
Real GDP per
per person in _ person in
current year
previous year
__________________________________
X 100%
Real GDP per
person in
previous year
$33,842 - $32,539
________________
$32,539
X 100%
= 4%.
The second method of calculating the growth rate of
real GDP per person is as follows:
Growth rate of
real GDP per
person
=
Growth rate of real
GDP
_
Growth rate of
population.
Using the data from our table, the growth rate of the
population from 2005 to 2006 is given by
_
275.4
million
272.9 million X 100%
__________________________
272.9 million
≈ 1%.
Recall that the growth rate of real GDP was
approximately 5%. Therefore,
Growth rate of
real GDP per
person
=
5% - 1% = 4%.
The rule of 70
Growth works like compound interest:
If you deposit $100 in a bank account at a 5%
annual interest rate, at the end of the year you will
have $100 + $5. If you leave the money in the bank
for another year, you will earn interest on the $100
and interest on the $5.
Because you are earning “interest on interest,” over a
period of years the initial deposit of $100 will
compound to a larger amount.
How many years will it take for the $100 to double to
$200? We use the “rule of 70” to estimate the answer.
The rule of 70 states that the number of years it takes
for the level of any variable to double is approximately
70 divided by the annual percentage growth rate of
the variable.
Thus, if the annual interest rate on our $100 deposit
is 5%, this means the $100 grows at an annual rate of
5%. Therefore the $100 will double to $200 in
70
___
= 14 years.
5
The same approach can be applied to economic
growth:
Thus, if a country’s real GDP per person grows at an
annual rate of 4%, that country’s real GDP per
person, i.e., its standard of living, will double in
70
___
= 17.5 years.
4
Sources of economic growth
Real GDP increases if we employ more labor.
Consider the aggregate production function:
Real GDP increases from $7 trillion to $10 trillion
when we increase aggregate hours of labor employed
from 100 billion to 200 billion per year.
Aggregate hours of labor employed can increase due
to an increase in
average hours
the labor force participation rate
population
But average hours worked per worker has actually
decreased over time. And although the labor force
participation rate has increased, it clearly has an
upper limit.
This leaves population growth as the only source of
growth in aggregate labor hours that is sustainable
over time.
But although population growth brings growth of real
GDP, it does not necessarily bring growth of real GDP
per person, i.e., growth of the standard of living,
unless labor becomes more productive.
Thus, our standard of living will improve only if we
produce more goods and services (more real GDP)
with each hour of labor.
If a given amount of labor produces more real GDP,
this means that the aggregate production function has
shifted up:
Assuming that 200 billion hours of labor are employed
per year, when the aggregate production function
shifts up, real GDP increases from $10 trillion to $12
trillion.
This increase in real GDP is due to an increase in
labor productivity, meaning that a given amount of
labor is able to produce more real GDP.
Labor productivity is the quantity of real GDP
produced on average by one hour of labor:
Labor productivity =
Real GDP
______________________
Aggregate hours
For example, if real GDP in a given year is $9 trillion
and aggregate hours of labor employed in the same
year is 200 billion, then labor productivity is:
$9 trillion
_____________________
200 billion hours
= $45 per hour.
This means that each hour of labor produces on
average $45 worth of goods and services.
Growth of labor productivity is required in order to
generate growth of real GDP per person. Therefore
growth of labor productivity is the fundamental cause
of growth of the standard of living, i.e., economic
growth.
Growth of labor productivity is caused by:
increases in the physical capital stock
increases in the stock of human capital
technological innovation
Increases in physical capital and human capital
require investment expenditures on plant and
equipment, in the case of physical capital, and
education and training, in the case of human capital.
These investment expenditures, in turn, require
saving in order to provide the funds for investment.
Efficient financial markets are necessary to channel
saving into productive investment expenditures.
Growth of human capital not only directly increases
labor productivity, but is also the source of discovery
of new technologies which, historically, has been the
most important contributor to growth of labor
productivity.
To take advantage of new technologies, physical and
human capital must increase. For example, firms
must invest in new computers to benefit from the
invention of a new, faster microprocessor; and
individual workers or their employers must invest in
new skills to be able to use a new technology.
Increases in physical and human capital and
technological innovation cause increases in labor
productivity, represented by an upward shift of the
aggregate production function.
Increases in real GDP occur through a combination
of increases in aggregate hours and increases in
labor productivity. But only an increase in labor
productivity can bring about an increase in real GDP
per person, i.e., an increase in the standard of living.
The increase in aggregate hours is shown as the
movement along the horizontal axis from 200 billion
hours to 250 billion hours.
The increase in labor productivity is shown as the
upward shift of the aggregate production function
from PF0 to PF1.
Real GDP per hour of labor, i.e., labor productivity,
has increased from
$10 trillion
__________________
200 billion hours
=
$50 per hour
=
$56 per hour.
to
$14 trillion
__________________
250 billion hours
Preconditions for economic growth
What conditions are necessary for economic growth?
We have seen that growth of real GDP per person
requires saving and investment to increase the stock
of physical capital, investment in human capital to
enhance the skills of the labor force, and technological
innovation.
A necessary condition for all of these is economic
freedom, which is freedom to exchange in markets
and enforcement of private property rights.
Property rights and markets create incentives for
individuals to specialize, trade, save, invest, expand
their human capital, and discover new technologies.
No country with a high level of economic freedom is
poor. But many countries that lack economic freedom
stagnate at low levels of per person real GDP.
Thus, as Adam Smith pointed out in his 1776 book,
The Wealth of Nations, the main cause of the wealth
of nations, i.e., the main determinant of economic
growth, is having the right institutions.