Chapter 7
Economic Growth:
Theory and Policy
Once one starts to think about . . . [differences in growth rates
among countries], it is hard to think about anything else.
ROBERT E. LUCAS, JR.
Three Pillars of Productivity Growth
• Growth policy
– High sustainable long-run growth
• Potential GDP
• Represented by production function
Y=zF(K,L)
• Stabilization policy
– Keep actual GDP
• Close to potential GDP - short run
• No high unemployment
• No high inflation
2
Three Pillars of Productivity Growth
• Labor productivity grows:
– Larger capital stock (K↑)
• Given technology & labor force
– Better technology (z↑)
• Given capital & labor
– Workforce quality (L↑)
• More education & training
• Given capital, technology, labor force
• Human capital (education & training)
– Amount of skill embodied in workforce
– Labor (L) = number of worker (N) * H
3
Figure 1
Production functions corresponding to three different
capital stocks
c
K3
b
K2
a
K1
Output
Yc
Yb
Ya
0
L1
Hours of Labor Input
4
Levels, Growth Rates, & Convergence
• Level of productivity
– Higher in rich countries
– Depends on
• Supply of human & physical capital
• State of technology
• Growth rate of productivity
– Depends on growth rates of
• Capital (K)
• Workforce skills (H)
• Technology (z)
5
Table 1
Productivity levels and productivity growth rates in
selected countries
Country
United States
France
United Kingdom
Spain
Ireland
Argentina
Mexico
Brazil
South Korea
GDP per hour of work 1980
(as percentage of U.S.)
GDP per hour of work 2005
(as percentage of U.S.)
Growth
rate
100
86
71
62
57
51
44
33
20
100
99
85
62
96
37
25
23
48
1.7
2.3
2.4
1.7
3.9
0.4
-0.5
0.2
5.4
6
Levels, Growth Rates, & Convergence
• Convergence hypothesis
– Nations with low levels of productivity
• High productivity growth rates
– International productivity differences
• Shrink over time
– Poorer countries
• Higher productivity growth
7
Figure 2
The Convergence Hypothesis
Real GDP per capita
Richer country
Poorer country
$10,000
$2,000
0
Time
8
Levels, Growth Rates, & Convergence
• Technological laggards
– Can close the income gap
– Imitation, not innovation
• Adopt existing technologies
– Example: Boeing 767 in domestic airline, cell
phone and internet access in China
– “Convergence club”
• Productivity growth rates - higher
– Where productivity levels are lower (South Korea,
China, India, Ireland, …)
• Poorest nations
– Unable to join
9
Table 2
Levels and growth rates of GDP per capita in
selected poor countries
Country
Belarus
Russia
Ukraine
Peru
Haiti
Burundi
Sierra Leone
GDP per capita
2005*
GDP per capita growth rate,
1990-2005
$1,868
2,445
960
2,337
434
105
218
2.0%
-0.4
-2.4
2.3
-2.4
-2.5
-0.9
*in constant 2000 U.S. dollars
10
Growth Policy: Capital Formation
• Nation’s capital
– Available supply
• Plant, equipment, software
– Result of past decisions – investments
• Investment
– Flow of resources
• Production of new capital
– Inputs
• Construction of capital
– Period of time
11
Growth Policy: Capital Formation
• Capital formation
– Investment
– Process of building up capital stock
• Trade-off
– More capital formation
• Quicker growth
• Consume less today
– More consumption today
• Less capital formation
• Slower growth
12
Figure 3
Investment Goods Produced
Choosing between investment and consumption
A
I
C
D
0
Consumer Goods Produced
13
Growth Policy: Capital Formation
• Speed up capital formation / investment
– Lower real interest rates
– Tax provisions
– Technical change
– Growth of demand
– Political stability
– Property rights
• Laws and/or conventions
• Owners - rights to use their property
14
Table 3
Selected countries ranked by level of investor
protection
Country
Singapore
United States
Canada
United Kingdom
Japan
Mexico
India
Sweden
Brazil
Italy
China
Swaziland
Rating (0-10 scale)
9.3
8.3
8.3
8.0
7.0
6.0
6.0
5.7
5.3
5.0
5.0
2.3
15
Growth Policy: Education & Training
• More-educated & better-trained workers
– Higher productivity
– Higher wages
• Education policy
– Improve quality of education
• Earning gap
• High school graduates
• College graduates
• On-the-job-training
– Skills acquired at work
16
Figure 4
Wage premium for college graduates over high
school graduates
17
Growth Policy: Technological Change
• Advancement of technology
– More education
• Scientific, engineering, managerial
– More capital formation
– Research & development (R&D)
• Inventing new products/processes
• Improving existing ones
• R&D – encouraged by government
– Tax credit
– Collaborative research
– Spending on R&D
18
Productivity Slowdown & Speed-up, U.S.
• 1948-1973: 2.8%
• 1973-1995 Productivity slowdown, 1.4%
– Lagging investment
– High energy prices
– Inadequate workforce skills
– Not: technological slowdown
19
Figure 5
Average productivity growth rates in the United
States, 1948–2007
20
Productivity Slowdown & Speed-up, U.S.
• 1995-2007 Productivity speed-up, 2.5%
– IT revolution
– Surging investment
– Falling energy prices
– Advances in information technology
21
Growth in the Developing Countries
• Poorly endowed with capital
– Difficult to accumulate capital
• Development assistance – foreign aid
– Outright grants & Low-interest loans
– From rich countries & multinational
institutions
– To spur economic development
22
Growth in the Developing Countries
• Foreign direct investment
– Purchase/construction
• Real business assets
– Multinational corporations
•
•
•
•
•
Low level of technology
Low levels of education & training
Poor geographical conditions
Poor health
Governance
23
Table 4
Average educational attainment in selected countries,
2000
United States
Canada
South Korea
Japan
United Kingdom
Italy
Mexico
India
Brazil
Sudan
12.3
11.4
10.5
9.7
9.4
7.0
6.7
4.8
4.6
1.9
For people older than 25 years of age
24
From the Long Run to the Short Run
• Over long periods of time
– Similar growth rates
• Actual GDP
• Potential GDP
• Macroeconomic fluctuations
– GDP shrinks – recessions
• Needed: a short-run theory of AD (next
chapter)
25
Summary
• Source of economic growth (K, z, and
H)
• Convergence hypothesis
• Growth policy
– Capital formation
– Improve education and training
– Spur technical change
• Productivity slowdown and speed-up
• Growth in the developing countries