Potential GDP and
Economic Growth
CHAPTER
17
CHAPTER CHECKLIST
When you have completed your study of this
chapter, you will be able to
1
Explain the forces that determine potential GDP and
the real wage rate and employment at full employment.
2
Define and calculate the economic growth rate, and
explain the implications of sustained growth.
3
Identify the main the sources of economic growth and
explain the growth process.
4
Describe the policies that might speed economic
growth.
MACROECONOMIC APPROACHES AND PATHWAYS
The Two Main Schools of Thought
The two main approaches to macroeconomics are based
on two schools of thought:
• Classical macroeconomics
• Keynesian macroeconomics
MACROECONOMIC APPROACHES AND PATHWAYS
Classical macroeconomics is a body of theory about
how a market economy works and why it experiences
economic growth and fluctuations.
The classical view is that markets work well and deliver
the best available macroeconomic performance.
The economy will fluctuate, and growth will slow down
from time to time.
But no government remedy can improve the
performance of the market.
MACROECONOMIC APPROACHES AND PATHWAYS
Classical macroeconomic fell into disrepute during the
1930s, which was a decade of high unemployment and
stagnant production throughout the world.
Great Depression is a decade (the 1930s) of high
unemployment and stagnant production throughout the
world economy.
Classical macroeconomics predicted that the Great
Depression would end but gave no method for ending it
more quickly.
MACROECONOMIC APPROACHES AND PATHWAYS
Keynesian macroeconomics is a body of theory about
how a market economy works that stresses it inherent
instability and the need for active government
intervention to achieve full employment and sustained
economic growth.
John Maynard Keynes, in his book “The General Theory
of Employment, Interest, and Money,” began this school
of thought.
Keynes’ theory was that too little consumer spending
and investment lead to the Great Depression.
MACROECONOMIC APPROACHES AND PATHWAYS
Keynes’ solution to depression and high unemployment
was increased government spending.
But Keynes predicted that his policy aimed at curing
unemployment in the short term might increase it in the
long term.
This prediction became reality during the 1960s and
1970s, when inflation exploded, growth slowed, and
unemployment increased.
It was time for another challenge to the mainstream:
new macroeconomics
MACROECONOMIC APPROACHES AND PATHWAYS
The New Macroeconomics
New macroeconomics is a body of theory about how a
market economy works based on the view that macro
outcomes depend on micro choices—the choices of
rational individuals and firms interacting in markets.
New classical macroeconomics incorporates the ideas
of classical economists that markets work and new
Keynesian macroeconomics incorporates the ideas of
Keynesian economists that markets adjust slowly.
MACROECONOMIC APPROACHES AND PATHWAYS
The key difference between the two new schools is in
their view of how quickly price and wages adjust in the
face of excess demand or excess supply.
But this difference is tiny, and a consensus is emerging.
The Road Ahead
We follow the new consensus and begin with an
explanation of what determines real GDP and
employment and the pace of economic growth.
17.1 POTENTIAL GDP
Potential GDP is the level of real GDP that the
economy would produce if it were at full employment.
We produce the goods and services that make up real
GDP by using factors of production: labor and human
capital, physical capital, land, and entrepreneurship.
At any given time, the quantities of human capital,
physical capital, land, entrepreneurship, and the state of
technology are fixed.
17.1 POTENTIAL GDP
The quantity of labor employed depends on the choices
of people and businesses.
So real GDP produced depend on the quantity of labor
employed.
To describe the relationship between real GDP and the
quantity of labor employed, we use a relationship called
the production function.
17.1 POTENTIAL GDP
The Production Function
Production function is a relationship that shows the
maximum quantity of real GDP that can be produced as
the quantity of labor employed changes and all other
influences on production remain the same.
17.1 POTENTIAL GDP
Figure 17.1 shows
the production
function.
100 billion hours of
labor can produce
$6 trillion of real
GDP at point A.
17.1 POTENTIAL GDP
200 billion hours of
labor can produce $10
trillion of real GDP at
point B.
300 billion hours of
labor can produce $12
trillion of real GDP at
point C.
The production function
PF is a limit to what is
attainable.
17.1 POTENTIAL GDP
The production function
is a boundary between
the attainable and the
unattainable.
The production function
displays diminishing
returns: The tendency
for each additional hour
of labor employed to
produce successively
smaller additional
amounts of real GDP.
17.1 POTENTIAL GDP
The Labor Market
The Demand for Labor
Quantity of labor demanded is the total labor hours
that all the firms in the economy plan to hire during a
given time period at a given real wage rate.
17.1 POTENTIAL GDP
Demand for labor is the relationship between the
quantity of labor demanded and real wage rate when all
other influences on firms’ hiring plans remain the same.
The lower the real wage rate, the greater is the quantity
of labor demanded.
17.1 POTENTIAL GDP
Figure 17.2
shows the
demand for
labor.
17.1 POTENTIAL GDP
The Supply of Labor
Quantity of labor supplied is the number of labor
hours that all the households in the economy plan to
work during a given time period and at a given real
wage rate.
Supply of labor is the relationship between the
quantity of labor supplied and the real wage rate when
all other influences on work plans remain the same.
17.1 POTENTIAL GDP
Figure 17.3
shows the
supply of
labor.
17.1 POTENTIAL GDP
The quantity of labor supplied increases as the real
wage rate increases for two reasons:
• Hours per person increase as the real wage rate
increases.
• The labor force participation rate increases as the
real wage rate increases.
17.1 POTENTIAL GDP
Labor Market Equilibrium
A rise in the real wage rate eliminates a shortage of
labor by decreasing the quantity demanded and
increasing the quantity supplied.
A fall in the real wage rate eliminates a surplus of labor
by increasing the quantity demanded and decreasing
the quantity supplied.
If there is neither a shortage nor a surplus, the labor
market is in equilibrium.
17.1 POTENTIAL GDP
Figure 17.4(a) shows
labor market equilibrium.
1. Full employment occurs
when the quantity of labor
demanded equals the
quantity of labor supplied.
2. Equilibrium real wage rate
is $30 an hour.
3. Full-employment quantity
of labor is 200 billion hours
a year.
17.1 POTENTIAL GDP
Full Employment and Potential GDP
When the labor market is in equilibrium, the economy is
at full employment.
When the economy is at full employment, real GDP
equals potential GDP.
17.1 POTENTIAL GDP
Figure 17.4(b) shows
potential GDP.
1. When the fullemployment quantity
of labor is 200 billion
hours a year,
2. Potential GDP is $10
billion.
17.2 THE BASICS OF ECONOMIC GROWTH
Economic growth is a sustained expansion of
production possibilities measured as the increase in real
GDP over a given period.
Calculating Growth Rates
Economic growth rate is the rate of change of real
GDP expressed as a percentage per year.
17.2 THE BASICS OF ECONOMIC GROWTH
To calculate this growth rate, we use the formula:
Growth of
real GDP =
Real GDP in
Real GDP in
current year – previous year
x 100
Real GDP in previous year
For example, if real GDP in the current year is $8.4
trillion and if real GDP in the previous year was $8.0
trillion, then the growth rate of real GDP is
Growth of
real GDP =
$8.4 trillion – $8.0 trillion
$8.0 trillion
x 100 = 5 percent.
17.2 THE BASICS OF ECONOMIC GROWTH
The standard of living depends on real GDP per person.
Real GDP per person is real GDP divided by the
population.
The contribution of real GDP growth to the change in
the standard of living depends on the growth rate of real
GDP per person.
17.2 THE BASICS OF ECONOMIC GROWTH
We use the above formula to calculate this growth rate,
replacing real GDP with real GDP per person.
Suppose, for example, that in the current year, when
real GDP is $8.4 trillion, the population is 202 million.
Then real GDP per person is $8.4 trillion divided by 202
million, which equals $41,584.
And suppose that in the previous year, when real GDP
was $8.0 trillion, the population was 200 million.
Then real GDP per person in that year was $8.0 trillion
divided by 200 million, which equals $40,000.
17.2 THE BASICS OF ECONOMIC GROWTH
Use these two values of real GDP per person in the
growth formula to calculate the growth rate of real GDP
per person. It is
$41,584 – $40,000
Growth rate of real
x 100 = 4 percent.
=
GDP per person
$40,000
17.2 THE BASICS OF ECONOMIC GROWTH
The growth rate of real GDP per person can also be
calculated by using the formula:
Growth of real
= Growth rate of –
GDP per person
real GDP
Growth rate of
population
Growth of
202 million – 200 million
x 100 = 1 percent.
=
population
200 million
17.2 THE BASICS OF ECONOMIC GROWTH
Growth of real
GDP per person = 5 percent – 1 percent = 4 percent.
This formula makes it clear that real GDP per person
grows only if real GDP grows faster than the
population grows.
If the growth rate of the population exceeds the growth
of real GDP, real GDP per person falls.
17.2 THE BASICS OF ECONOMIC GROWTH
The Magic of Sustained Growth
Sustained growth of real GDP per person can transform
a poor society into a wealthy one. The reason is that
economic growth is like compound interest.
Rule of 70 is 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.
17.2 THE BASICS OF ECONOMIC GROWTH
Table 17.1 Growth Rates
Growth rate
(% per year)
2
7
Years for level
to double
35
10
Example
U.S. real GDP per person
China real GDP per person
17.3 THE SOURCES OF ECONOMIC GROWTH
To understand what determines the growth rate of real
GDP, we must understand what determines the growth
rates of the factors of production and rate of increase in
their productivity.
All the influences on real GDP growth can be divided
into those that increase
• Aggregate hours
• Labor productivity
17.3 THE SOURCES OF ECONOMIC GROWTH
Aggregate Hours
Over time, aggregate hours increase. This growth in
aggregate hours comes from growth in the labor force
rather than from growth in average hours per worker.
While the participation rate has increased over the past
few decades, it has an upper limit, and most of the
growth of aggregate hours comes from population
growth.
So population growth is the only source of growth in
aggregate labor hours that can be sustained over long
periods.
17.3 THE SOURCES OF ECONOMIC GROWTH
Population growth brings economic growth, but it does
not bring growth in real GDP per person unless labor
becomes more productive.
Labor Productivity
Labor productivity is the quantity of real GDP
produced by one hour of labor.
It is calculated by using the formula:
Labor productivity =
Real GDP
Aggregate hours
17.3 THE SOURCES OF ECONOMIC GROWTH
For example, if real GDP is $8,000 billion and if
aggregate hours are 200 billion, then we can calculate
labor productivity as
Labor productivity =
$8,000 billion
= $40 per hour
200 billion
You can turn this formula around and see that
Real GDP = Aggregate hours x Labor productivity
17.3 THE SOURCES OF ECONOMIC GROWTH
When labor productivity grows, real GDP per person
grows, so the growth in labor productivity is the basis of
rising living standards.
The growth of labor productivity depends on three
things:
• Saving and investment in physical capital
• Expansion of human capital
• Discovery of new technologies
17.3 THE SOURCES OF ECONOMIC GROWTH
Saving and Investment in Physical Capital
Saving and investment in physical capital increase the
amount of capital per worker and increase labor
productivity.
Expansion of Human Capital
Human capital—the accumulated skill and knowledge of
people—comes from two sources:
• Education and training
• Job experience
17.3 THE SOURCES OF ECONOMIC GROWTH
Discovery of New Technologies
To reap the benefits of technological change, capital
must increase.
Some of the most powerful and far-reaching
technologies are embodied in human capital.
For example, language, writing, and mathematics.
But most technologies are embodied in physical capital.
17.3 THE SOURCES OF ECONOMIC GROWTH
Sources of Growth: A Summary
Figure 17.5 shows the sources of economic growth.
Real GDP growth depends on aggregate labor hours
growth and on labor productivity growth.
17.3 THE SOURCES OF ECONOMIC GROWTH
Aggregate hours growth depends on
• Population growth
• The labor force participation rate
• Average hours per worker
17.3 THE SOURCES OF ECONOMIC GROWTH
Labor productivity growth depends on
• Physical capital growth
• Human capital growth
• Technological advances
17.3 THE SOURCES OF ECONOMIC GROWTH
Figure 17.6 illustrates
the growth process as a
perpetual motion
machine.
1. People want a
higher standard of
living and are
spurred by...
2. Profit incentives to
make the...
3. Innovations that
lead to...
17.3 THE SOURCES OF ECONOMIC GROWTH
4. New and better
techniques and new and
better products, which in
turn lead to...
5. The birth of new
firms and the death
of some old firms,
6. New and better
jobs, and...
7. More leisure and more
consumption goods and
services.
17.3 THE SOURCES OF ECONOMIC GROWTH
The result is...
8. A higher
standard of
living.
But people want a
yet higher standard
of living, and the
growth process
continues.
25.4 ACHIEVING FASTER GROWTH
Preconditions for Economic Growth
Economic freedom is the fundamental precondition for
creating the incentives that lead to economic growth.
Economic freedom is a condition in which people are
able to make personal choices, their private property is
protected, and they are free to buy and sell in markets.
25.4 ACHIEVING FASTER GROWTH
Economic freedom requires the protection of private
property—the factors of production and goods that
people own.
Property rights are the social arrangements that
govern the protection of private property.
Economic freedom also requires free markets.
25.4 ACHIEVING FASTER GROWTH
To achieve faster economic growth, we must increase
• The growth rate of capital per hour of labor or
• The growth rate of human capital or
• The pace of technological advance.
25.4 ACHIEVING FASTER GROWTH
Policies to Achieve Faster Growth
The main actions that governments can take to achieve
these objectives are
•
•
•
•
•
Create the incentive mechanisms
Encourage saving
Encourage research and development
Encourage international trade
Improve the quality of education
25.4 ACHIEVING FASTER GROWTH
Create Incentive Mechanisms
Economic growth occurs when the incentive to save,
invest, and innovate is strong enough. These incentives
exist only when private property is protected.
Encourage Saving
Saving finances investment, which brings capital
accumulation.
Tax incentives can encourage saving, increase the
growth of capital, and stimulate economic growth.
25.4 ACHIEVING FASTER GROWTH
Encourage Research and Development
Everyone can use the fruits of basic research and
development efforts.
Because basic inventions can be copied, the inventor’s
profit is limited and so the market allocates too few
resources to this activity.
Governments can direct public funds toward financing
basic research, but it requires a mechanism for
allocating public funds to their highest-valued use.
25.4 ACHIEVING FASTER GROWTH
Encourage International Trade
Free international trade stimulates economic growth by
extracting all the available gains from specialization and
trade.
Improve the Quality of Education
By funding basic education and by ensuring high
standards in skills such as language, mathematics, and
science, governments can contribute enormously to a
nation’s growth potential.
25.4 ACHIEVING FASTER GROWTH
How Much Difference Can Policy Make?
A well-intentioned government cannot dial up a big
increase in the growth rate.
But it can pursue policies that will nudge the growth rate
upward.
And over time, the benefits from these policies will be
large.