Chapter 6: Economic Growth

What is economic growth? (2)

1. Expansion of PPF (represented by an outward shift in the PPF)

2. Expansion of potential GDP (year to year increase)

How do we measure economic growth?

Growth of real GDP

g = (logY t + 1) - (logYt)

Correlation ≠

causation!!!

Benefits of economic growth for a country

• Correlation between income and other socioeconomic indicators (education, health, etc.)

• Distribution and scale of economic activities

Costs of economic growth for a country

• Current consumption

• Resource utilization

• Pollution

• Biodiversity loss

• Climate change

Alternative literature (antithesis) for economic growth

1. Degrowth theory

2. Agrowth theory

3. Decoupling

4. Steady state economy

What is the rule of 70? (Sometimes 72)

If a variable starts at an initial value at some time, the value ends up being the same on both sides (LS = RS)

Formula for rule of 70

Yt = Yo (1 + g) ^ t

Magic formula

z = 70 / g

What’s the magic of economic growth?

Even a small percentage change can make a HUGE difference in years! (ex 1% - 2%)

Advanced countries have slower or quicker economic growth?

Slower

What is productivity? Neoclassical economics says…

A country’s standard of living is dependant on its ability to produce goods and services

Productivity =

What we can produce in 1 hour

Production is affected by…

The factors of production

Production function =

Y = AF(K, L T, H)

Where…

Y = Output

A = Technology level

Short version

Y = AF(K, L)

Labour productivity =

Y / L

Production function shows…

Relationship between inputs (technology) and outputs.

What are the characteristics of the productivity function?

1. Positive / diminishing marginal returns on input

2. Constant returns to scale

Positive / diminishing marginal returns on input means…

Slope is positive but decreasing. MP(L) decreases, MP(K) decreases.

Constant returns to scale means…

If you multiply input or output by any value, LS = RS

Function that shows constant returns to scale?

Douglas production function:

Y = A (K ^ α) * (L  ^ 1 - α)

3 kinds of returns to scale

1. Increasing

2. Diminishing

3. Constant

What is potential GDP?

What an economy can produce with FULL employment

What is full employment?

Only natural rate of unemployment exists (structural, frictional)

How can we determine potential GDP?

1. Aggregate production function

2. Aggregate labor market

Aggregate production function is…

Y = AF(K, L, …)

Aggregate labor market is…

Quantities: Ld, Ls

Prices: W, W/p         (nominal and real wage rate)

Nominal vs. Real wage rate

$ vs. purchasing power

Equilibrium in the labor market exists when…

Ls = Ld

Labor demanded (Ld)

1. Relationship between W/p and Ld

2. Negative convex

3. Derived from employer and business needs

Labor supplied (Ls)

1. Relationship between W/p and Ls

2. Positive convex

3. Derived from labor / leisure choice

What are the determinants of potential GDP?

• Labor (L)

• Capital (K)

• Land (T)

• Entrepreneurship (H)

Labor is affected by the growth of 2 things:

1. Ls

2. Labor productivity

How is growth in Ls shown?

• Average hours worked

• Employment to population ratio

• Growth in working age population

Quantity of Ls formula 

= (# of workers employed) * (average # of hours worked) * (employment level / working age population)

A movement ___ the curve happens when Ls changes

ALONG

Labor supply moves to the right (increases), which means…

Potential GDP increases! (Movement along the curve)

Labor productivity =

Y / L

A ______ the curve happens when Y/L changes

SHIFT in

Is economic growth sustainable?

Literature / growth models:

1. Classical growth theory

2. Neoclassical growth theory

3. New growth theory

Who did classical growth theory?

Adam Smith

Who did neoclassical growth theory?

• Robert Solow

• Trevor Swan

Who did new growth theory

Robert Solow

Classical growth theory says…

Growth is temporary, and eventually an explosion sets real GDP per person back to subsistence!

Neoclassical growth theory says…

Real GDP per person only grows because of savings and investments. (By CHANCE, and definite.)

New growth theory says…

Real GDP per person can always grow when people make choices in pursuit of profit. Because knowledge is not subject to diminishing return, and discoveries are a public capital good. (By CHOICE, and indefinite)