Chapter 6: Economic Growth
• Estimate economic growth and implications of sustained
growth for standard of living.
• Trends in economic growth in U.S. and rest of world.
• Sources of economic growth
• Alternative theories and policies to improve growth.
The Basics of Economic Growth
Economic growth
•the sustained expansion of production possibilities
•measured as the increase in real GDP over a given period.
Economic growth rate = annual % change of real GDP.
•Between two consecutive years:
growth rate = (X2/X1)-1
•Over several years:
Annualized growth rate = (XT/X1)1/T – 1
The Basics of Economic Growth
•Standard of living depends on real GDP per person.
•Real GDP per person grows only if real GDP grows faster
than the population grows.
• Rule of 70
number of years it takes for the level of a variable to
double is approximately 70 divided by the annual
percentage growth rate of the variable
Trends in U.S Economic Growth
Growth in the U.S. Economy
From 1908 to 2008, annual growth in real GDP per
person in the United States averaged 2% .
Real GDP per person fell precipitously during the Great
Depression and rose rapidly during World War II.
Growth was most rapid during the 1960s.
Growth slowed during the 1970s and sped up again in
the 1980s and1990s.
Trends in U.S Economic Growth
Economic Growth Trends
Real GDP Growth in Developed Countries
Growth in the
United States,
Canada, and
Europe Big 4
has been
similar.
Japan grew
rapidly in the
1960s, slower in
the 1980s, and
even slower in
the 1990s.
Economic Growth in U.S. vs. Poor
Countries
 The gaps
between real GDP
per person in the
United States and in
these countries have
widened.
Some economies
are converging
Some are
diverging
Sources of Economic Growth
Economic growth is the sustained, year-on-year increase
in potential GDP.
•Potential GDP is the quantity of real GDP produced
when the quantity of labor employed is the fullemployment quantity.
•Short run fluctuations in real GDP resulting from the
business cycle are not the basis for economic growth
Determinants of Potential GDP
Aggregate production
function
•Real GDP changes as the
quantity of labor changes, other
things held constant.
•An increase in labor increases
real GDP.
•Diminishing marginal returns
cause RGDP to rise at slower
rate as L rises
Determinants of Potential GDP
Aggregate Labor Market
•real wage rate
– money wage rate divided by the price level.
•demand for labor
– shows the quantity of labor demanded as a function of the
real wage rate.
– determined by the marginal product of labor
•supply of labor
–shows the quantity of labor supplied as a function of the
real wage rate.
The Labor Market and Potential GDP
Labor Demand Curve
The demand for labor is the relationship between the
quantity of labor demanded and the real wage rate
when all other influences on hiring plans remain the
same.
Marginal product of labor curve is same as labor demand
curve
 Firms will always hire workers if MP> real wage
 Profit maximizing firm hires until MP= real wage
The Labor Market and Potential GDP
Labor supply curve
shows quantity of labor supplied for each real wage rate.
Quantity of labor supplied increases as the real
wage rate increases for two reasons:
1. Hours per person increase (assuming IE<SE)
Income effect (work less if real wage increases)
Substitution effect (work more if real wage increases)
2. Labor force participation increases
Determinants of Potential GDP
How Potential GDP Grows
Increase in the supply of Increase in demand for
labor
labor
• taxes on workers
• population growth
• demographics
• retirement incentives
• household technology
• more productive labor
•Human capital
• physical capital
• technological improvements
• reduced payroll taxes on
employers
Effect of increase in labor supply
• real wage
• labor hours
• real GDP
• productivity (RDGP per hour)
• real GDP per capita
•depends on whether population increased
Effect of increase in labor demand due to
increased productivity
•Labor demand increases and PF shifts upward.
•real wage
• labor hours
• real GDP
• productivity
• real GDP per capita
Effect of increase in labor demand due to
increased productivity
Why Labor Productivity Grows
The incentive system created by firms, markets, property
rights, and money.
The growth of labor productivity depends on
•
Physical capital growth
•
Human capital growth
•
Technological advances
Accounting for Growth
The quantity of real GDP produced, Y, depends on the
quantity of labor, L, the quantity of capital, K, and the state
of technology, T.
Growth accounting
•calculates the contribution of capital growth and
technological change to labor productivity growth.
One third rule (Robert Solow)
• Estimated effects of capital on labor productivity
•On average, with no change in technology, a 1 percent
increase in capital per hour of labor brings a 1/3 percent
increase in labor productivity
Why Labor Productivity Grows
Between 1973 and
1983, growth of labor
productivity slowed to 1.7
percent a year.
A collapse in the
contribution of
technological change
(purple bar) brought
about this slowdown in
the growth of labor
productivity.
Why Labor Productivity Grows
Labor productivity
growth rate increased to
2 percent a year
between 1983 and 1993
and …
to almost 3 percent
between 1993 and
2008.
Technological change
contributed most to this
speedup in the growth
of labor productivity.
Growth Theories and Policies
Classical growth theory
•growth of real GDP per person is temporary and that
when GDP per person rises above the subsistence level,
a population explosion eventually brings real GDP per
person back to the subsistence level.
•Malthus – the “dismal science”
Growth Theories and Policies
Modern Growth Theory
Real GDP per person grows because technological
change induces a level of saving and investment that
makes capital per hour of labor grow.
Growth ends only if technological change and/or
incentives for technological change stops.
Growth Theories and Policies
New growth theories
• Real GDP per person grows because of choices that
people make in the pursuit of profit and growth can
persist indefinitely.
•Technological change is driven by profit incentives
• Knowledge is a public good and there may be
increasing returns to knowledge (education)
Growth Theories and Policies
Achieving Faster Growth
Growth accounting tells us that to achieve faster
economic growth we must either increase the growth rate
of capital per hour of labor or increase the pace of
technological change.
Stimulate Saving
•Saving finances investment. So higher saving rates
might increase physical capital growth.
•Tax incentives might be provided to boost saving.
Growth Theories and Policies
Stimulate Research and Development
•Because the fruits of basic research and development
efforts can be used by everyone, not all the benefit of a
discovery falls to the initial discoverer.
•The market might allocate too few resources to
research and development.
•Government subsidies and direct funding might
stimulate basic research and development.
• Patents can provide incentive to innovate.
Growth Theories and Policies
Encourage International Trade
•Free international trade stimulates growth by extracting
all the available gains from specialization and trade.
•The fastest growing nations are the ones with the fastest
growing exports and imports.
Improve the Quality of Education
•The benefits from education spread beyond the person
being educated, so there is a tendency to under invest in
education.