Topic 4
Economic Growth
and
Rising Living Standards
1
Real GDP per Person, 1870-2003 (in 2000 US $)
2
Real GDP per Capita, 1870 - 2003
Country
1870
1913
1950
1979
2003
US
$2,936
$6,366
$11,484
$22,567
$34,875
UK
3,899
6,014
8,481
16,093
26,046
Germany
2,420
2,800
5,106
18,411
25,188
Japan
835
1,571
2,176
14,912
24,037
Brazil
923
100
2,165
6,336
7,205
China
548
571
464
1,076
4,970
Ghana
464
826
1,187
1,281
1,440
3
Growth of Real GDP per Capita, 1870 - 2003
Annual %
Change
1870 – 2003
Annual %
Change
1950 – 2003
Annual %
Change
1979 - 2003
US
1.9%
2.1%
1.8%
UK
1.4
2.1
2.0
Germany
1.8
3.1
1.3
Japan
2.6
4.6
2.0
Brazil
1.6
2.3
0.5
China
1.7
4.6
6.6
Ghana
0.9
0.4
0.5
Country
4
Arithmetic of Growth: Rule of 70
Approximate
number of years
required to double
real GDP
70
=
annual percentage rate
of growth
Economic Growth
• What determines the potential output?
– Labor productivity or Productivity
Amount of output average worker can produce in an hour
– Average hours of labor
Number of hours average worker spends at the job
– Labor force participation rate (LFPR)
Fraction of population that wants to work
– Size of population
6
What Determines the Potential Output?
• Labor productivity
Total real output
Output per hour 
Total hours of labor
7
What Determines the Potential Output?
• Average hours of labor
Average hours 
Total hours of labor
Labor force
8
What Determines the Potential Output?
• Labor force participation rate (LFPR)
Labor force
LFPR 
Population
9
What Determines the Potential Output?
• Breaking down the total output
Total output 
Total output
Total hours of labor Labor force


 Population
Total hours of labor
Labor force
Population
Total output  Labor productivi ty  Average hours  LFPR  Population
10
What Determines the Potential Output?
• Review of some linear algebra
If Z = X ∙ Y, then % Δ Z ≈ % ΔX + % ΔY
If Z = X / Y, then % Δ Z ≈ % ΔX - % ΔY
Note: % Δ means percentage change.
• Applying this rule to the equation of total output
11
Economic Growth
• What matters for a rising standard of living is real
GDP per capita (i.e. per person)
Since
- Total output = Productivity x Average Hours x LFPR x Population
Then
- Output per capita = Total output ÷ Population
Output per capita = Productivity x Average Hours x LFPR
In terms of percentage growth rates
%Output per capita  %Productivi ty  %Average hours  %LFPR
12
Economic Growth
• A tendency in most developed countries is that
average hours of labor are slowly decreasing
So our last simplification is to ignore changes in
average hours in the equation
% Δ Output per person ≈ % Δ productivity + % Δ LFPR
13
Growth in the Labor Force
Participation Rate (LFPR)
Recall that
LFPR 
Labor Force
Population
So, %LFPR  %Labor force - %Population
14
Growth in the Labor Force
Participation Rate (LFPR)
• Currently, U.S. Bureau of Labor Statistics predicts the
employment growth rate to be 1% per year until 2010,
about the same as the growth rate of population
– If so, the % Δ LFPR ≈ % Δ Labor force - % Δ Population = 0
– Is there anything we can do to make the labor force
grow faster than population, and thus increase the rate
of economic growth?
• Yes
 Increase labor supply
 Increase labor demand
15
Figure 1: An Increase in Labor
Supply
16
Figure 2: An Increase in Labor
Demand
17
Figure 3: The U.S. Labor Market
Over A Century
18
How To Increase Employment
• Supply side
– Cut income tax
• Paying 40% of one’s income as taxes (federal, state, and local)
discourages work effort in the United States.
• Tax cut would provide incentives to people to seek jobs
• Labor supply curve shifts rightward
– Changes in government transfer programs
• Reduce social benefits
19
How To Increase Employment
• Demand side
– Government policies that help increase skills of the
workforce or that subsidize employment
• government-sponsored training programs
• aid to college students
• employment subsidies to firms
20
Growth in Productivity
• Recently, virtually all growth in the average
standard of living can be attributed to growth in
productivity
• What can we do to make productivity grow?
21
Figure 4: Capital Accumulation and
Labor Productivity
22
Growth in the Capital Stock
• One key to productivity growth is growth in nation’s capital
stock
– With more capital, a given number of workers can produce more
output than before
• Growth in capital stock will increase productivity as long as
it increases amount of capital per worker
Total capital stock
Since capital per worker 
,
Labor force
% capital per worker  % Total capital stock - % Labor force
23
Investment and the Capital Stock
• A stock variable measures a quantity at a moment in time
– Capital stock is a measure of total plant and equipment
in economy at any moment
• A flow variable measures a process that takes place over
a period of time
– Planned investment is a flow variable
• Depreciation is decrease in the value of assets
– As long as investment is greater than depreciation, total
stock of capital will rise
– The greater the flow of investment, the faster will be the
rise in capital stock
24
Targeting Businesses – Demand Side
Reducing business taxes
• Corporate profits tax
– A cut in tax on profits earned by corporations
• Investment tax credit
– A cut in taxes for firms that invest in certain favored types of capital
• Reducing business taxes or providing specific investment
incentives can shift the investment curve (the demand
curve in the loanable funds market) rightward
25
Figure 5: An Increase In Investment
Spending
26
Targeting Households – Supply Side
• If households decide to save more of their incomes at any given
interest rate
– Supply of loanable funds curve will shift rightward
• What might induce households to increase their saving?
–
–
–
–
–
Greater uncertainty about economic future
Increase in life expectancy
Anticipation of an earlier retirement
Change in tastes toward big-ticket items
Change in attitude about saving
• Any of these changes—if they occurred in many households simultaneously—
would shift saving curve to the right
• What can government do to increase household saving?
– One often-proposed idea is to decrease capital gains tax
27
Figure 6: An Increase In Savings
28
Government’s Budget Deficit
• A increase in government purchases tends to raise interest
rates
• High interest rates discourage business investments
So, to induce businesses to invest more, government should
reduce its purchases
–Shrinking deficit or rising surplus tends to reduce interest rates and
increase investment
–However, the effect on economic growth depends on how the budget
changes
29
Figure 7: Deficit Reduction and
Investment Spending
30
Human Capital and Economic Growth
• Human capital
– Skills and knowledge possessed by workers
• An increase in human capital works like an increase in
physical capital to increase output
– Causes production function to shift upward
• Raises productivity and increases average standard of living
• Human capital investments
– Education
31
Technology and Economic Growth
• Another source of growth is technological change
– Invention or discovery of new inputs, new outputs, or new methods
of production
• New technology affects economy in much the same way
as do increases in capital stock
– Shifts production function upward
• Since it enables any given number of workers to produce more
output
• Investments in technology
– R&D
32
Accounting for Growth
• Factors affecting productivity growth
–Technological advance (40%)
–Quantity of capital (30%)
–Education and training (15%)
–Economies of scale and resource
allocation (15%)
Economic Growth
• Is economic growth desirable and
•
•
sustainable?
The antigrowth view
–Environmental and resource issues
In defense of economic growth
–Higher standard of living
–Human imagination can solve
environmental and resource issues
Economic Growth
• Growth is the path to greater material
•
•
•
•
abundance
Results in higher standards of living
Increases leisure time
Allows for the expansion and application of
human knowledge
Global Competitiveness:
http://en.wikipedia.org/wiki/Global_Competitiveness_
Report#2011.E2.80.932012_rankings
Economic Growth in China
•
•
•
•
•
•
•
Growth averages in the past 25 years:
– 9% annual growth output
– 8% annual growth output per capita
Labor more productive
More international trade
Transition to market economy
Joined WTO 2001
Financial system remains weak
Income inequality across areas