ECN60204 Macroeconomics
LECTURE 1
Introduction to Macroeconomics :
What is Economic Growth and
Potential Output
Parkin, Ch 23
Hubbard, Ch 21 & 22
1
Learning Outcome
After this lecture you should be able to:
• Define economic growth and explain the implications of
sustainable growth.
• Describe economic growth trends.
• Distinguish between potential and actual GDP
• Understand what determines growth in potential GDP
• Understand how to use the labour market and the production
function to explain rises in potential GDP
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The Scope of Macroeconomics
Microeconomics vs Macroeconomics
The major Macroeconomic issues
• economic growth
• unemployment
• inflation
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The Basics of Economic Growth
Malaysia: % change in real GDP
12,0%
Economic growth is the
sustained expansion of
production possibilities
measured as the increase
in real GDP over a given
period.
The Business Cycle
10,0%
8,0%
6,0%
average
trend 4.5%
4,0%
2,0%
Sept 11
downturn
0,0%
-2,0%
Global
downturn
-4,0%
-6,0%
-8,0%
-10,0%
Asian
crisis
The economic growth rate is the annual percentage change in real GDP
The economic growth rate tells us how rapidly the total economy is
expanding (or contracting)
We are also interested in economic growth over the long run
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Economic growth (average % per annum)
1960–9
1970–9
1980–9
1990–9
2000–9
2010-18
France
5.6
4.0
2.4
2.0
1.5
1.4
European OECD
Japan Union members Brazil China India Malaysia Singapore
10.4
5.0
5.6
5.9
3.4
3.9
6.5
8.9
4.3
3.6
3.6
8.5
7.4
2.9
8.2
9.2
4.3
2.3
3.0
3.0
9.7
5.7
5.9
7.8
1.5
2.2
2.6
1.9 10.0
5.8
7.2
7.2
0.5
1.6
1.7
3.4 10.4
6.3
4.8
5.4
1.4
1.6
2.0
1.4
7.8
7.0
5.4
5.2
Why do economic growth rates matter?
An economy that grows too slowly
fails to raise living standards
The Rich Get Richer……
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What is the use of Economic Growth rates?
• Assess economic performance - our present & future wellbeing
depends on the performance of our industries and government as
well as our access to foreign goods and services
• Regulation of the business cycle. If not:
• Unemployment: resources not fully utilised – poverty, social
unrest
• Inflation: lowers your spending power – widens gap between
rich and poor, social unrest.
• Governments need to know how much to tax us & spend to
ensure enough funds for schools, hospitals, etc
• Link between interest rates, money supply and financial
markets
• Promote long term economic growth
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Economic Growth & the business cycle
Actual and Potential economic growth
• actual growth
– the % increase in actual output
• potential economic growth
– the % increase in the economy’s capacity
12,0%
10,0%
Actual
GDP
8,0%
Malaysia: %
change in real
GDP
6,0%
4,0%
2,0%
0,0%
-2,0%
-4,0%
-6,0%
-8,0%
-10,0%
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Long Run
trend 4.5%
Growth and the production possibility curve
Unable to
increase actual
output to point d
Good X
d
c
b
a
Growth in
actual output
O
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Good Y
Growth and the production possibility curve
Good X
Growth in
potential output
x
I
O
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Good Y
II
Growth and the production possibility curve
Good X
Growth in potential
output allows
actual
output to rise
y
The PPC does
not capture the full
impact of growth
on the economy
x
I
O
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Good Y
II
Long-term economic growth
Causes of long-term growth
• increases in the quantity of factors of production:
labour, land and capital
– the problem of decreasing returns can set in
• increases in factor productivity
– total factor productivity
The above issues requires
more investigation
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Potential GDP and Economic Growth
Potential GDP is the quantity of real GDP produced when
all factors of production are producing at full capacity
Potential GDP is the quantity of real GDP produced when
factors of production are at full employment.
For instance: when the quantity of labor employed is at
full-employment, the economy has reached its potential
GDP
To determine potential GDP we use a model with two
components:
The
production function
The
labor market
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Aggregate Production Function
 The aggregate
production function tells
us how real GDP changes
as the quantity of labor
changes (ceteris paribus,
when all other influences
on production remain the
same)
 An increase in labor
increases real GDP.
Q. What increases
labour hours?
13
The Aggregate Labor Market
The real wage rate is the money
wage rate divided by the price level.
LD curve: shows the quantity of
labor demanded and the real wage
rate.
LS curve: the quantity of labor
supplied and the real wage rate.
The labor market is in equilibrium at
which LD = LS at $35 per hour, 200
billion labour hours employed
At a real wage rate > $35 an hour, there is a surplus of labor
LS > LD and the real wage rate .
At a real wage rate < $35 an hour, there is a shortage of labor
(LD > LS) and the real wage rate 
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Potential GDP
 The quantity of real GDP
produced when the
economy is at full
employment is potential
GDP.
 When the fullemployment quantity of
labor is 200 billion hours,
potential GDP is $12
trillion.
15
What Makes Potential GDP Grow?
We begin by dividing real GDP growth into the forces that
increase:

Growth in the supply of labor (increase in factor of
production)

Growth in labor productivity (rise in factor productivity):

Physical capital growth

Human capital growth

Technological advances
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highways, telecomm,
buildings, factories, machinery
education, training,
workshops, schools,
universities
The Effects of Population Growth
on Potential GDP Grows
 Figure illustrates the effects of
population growth in the labor
market.
 The labor supply curve shifts
rightward.
 The real wage rate falls
 and aggregate hours increase.
The increase in the
aggregate hours increases
potential GDP.
17
Diminishing Returns
 The increase in aggregate
hours increases potential
GDP…but…
 Because of decreasing returns,
…...decreases real GDP per
hour of labor.
Population growth increases
aggregate hours and aggregate
real GDP, but to increase real
GDP per person, labor must
become more productive.
18
Growth in Labor Productivity
Labor productivity is the quantity of real GDP produced
by an hour of labor.
Labor productivity equals real GDP divided by aggregate
labor hours.
Suppose:
We find some way of making labor become more
productive e.g. more skillful, more efficient.
Firms would be willing to pay more for a given hour so the
demand for labor increases.
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How Potential GDP
Grows?
18

C
 Figure shows the effect of an
increase in labor productivity.
 The increase in labor
productivity shifts the
production function upward.
In the labor market:
An increase in labor productivity
increases the demand for labor.
The shortage in labor results in a
rise in the real wage
and aggregate hours increase
Potential GDP rises to $18 trill.
20
How Labor
Productivity Grows
The growth of labor productivity
depends on

Physical capital growth

Human capital growth

Technological advances
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Labor Productivity Growth
Physical Capital Growth e.g. machinery, infrastructure
(buildings, roads, rail, etc)
The accumulation of new capital increases capital per
worker and increases labor productivity.
Human Capital Growth is the most fundamental source of
labor productivity growth.
- on-the-job training, learning-by-doing (job experience)
- education, workshops, seminars, etc
Technological Advances
Technological change—the discovery and the application of
new technologies and new goods—has contributed
immensely to increasing labor productivity.
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Effect of technological progress on
growth rates & potential output
Output
Trend line becomes
steeper - potential
output grows
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Higher rate
of technological
progress
Lower rate
of technological
progress
Time
Next Week
Lecture 2: The Macroeconomic
Environment: GDP and Business
Fluctuations
Tutorial 1: Economic Growth (Bring
along MIB and Study Guide)
In future tutorials – require calculators
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