Economics 1020 - Chapter 6

Economic Growth

The Basics of Economic Growth

• Economic growth is the sustained expansion of production possibilities measured as the increase in real GDP over a given period.

Calculating Growth Rates

• The economic growth rate is the annual percentage change of real GDP.

• The economic growth rate tells us how rapidly the total economy is expanding.

Real GDP Per Person

• The standard of living depends on real GDP per person.

• Real GDP per person is real GDP divided by the population.

• Real GDP per person grows only if real GDP grows faster than the population grows.

Economic Growth Versus Business Cycle Expansion

• Real GDP can increase for two distinct reasons:

1. The economy might be returning to full employment in an expansion phase of the business cycle.

2. Potential GDP might be increasing.

• The return to full employment in an expansion phase of the business cycle isn’t economic growth.

• The expansion of potential GDP is economic growth.

The Magic of Sustained Growth

• The Rule of 70 states that the 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.

Long-Term Growth in Canada

• Growth of real GDP per person in Canada from 1926 to 2022 averaged 2 percent a year.

• 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 1980s, increased in the 1990s, and slowed again after 2000.

How Potential GDP Grows

• Economic growth occurs when real GDP increases.

• But a one-shot increase in real GDP or a recovery from recession is not economic growth.

• Economic growth is the sustained, year-on-year increase in potential GDP.

What Determines Potential GDP?

• Potential GDP is the quantity of real GDP produced when the quantity of labour employed is the full-employment quantity.

• To determine potential GDP we use a model with two components:

  • An aggregate production function

  • An aggregate labour market

How Potential GDP Grows - Aggregate Production Function

• The aggregate production function tells us how real GDP changes as the quantity of labour changes, other things remaining the same.

How Potential GDP Grows - Aggregate Labour Market

• The demand for labour shows the quantity of labour demanded and the real wage rate.

• The real wage rate is the money wage rate divided by the price level.

• The supply of labour shows the quantity of labour supplied and the real wage rate.

• The labour market is in equilibrium at the real wage rate at which the quantity of labour demanded equals the quantity of labour supplied.

Potential GDP

• The quantity of real GDP produced when the economy is at full employment is potential GDP.

What Makes Potential GDP Grow?

• We begin by dividing real GDP growth into the forces that make potential GDP grow into two categories:

  • Growth in the supply of labour

  • Growth in labour productivity

Growth in the Supply of Labour

• Aggregate hours, the total number of hours worked by all the people employed, change as a result of changes in:

1. Average hours per worker

2. Employment-to-population ratio

3. The working-age population growth

• Population growth increases aggregate hours and real GDP, but … to increase real GDP person, labour must become more productive.

The Effects of Population Growth

• An increase in population increases the supply of labour.

• With no change in the demand for labour, the equilibrium real wage rate falls and the aggregate hours increase.

• The increase in the aggregate hours increases potential GDP.

Growth of Labour Productivity

• Labour productivity is the quantity of real GDP produced by an hour of labour.

• Labour productivity equals real GDP divided by aggregate labour hours.

• If labour become more productive, firms are willing to pay more for a given number of hours, so the demand for labour increases.

How Potential GDP Grows - In the Labour Market

• An increase in labour productivity increases the demand for labour.

• With no change in the supply of labour, the real wage rate rises … and aggregate labour hours increase.

• And with the increase in aggregate hours, potential GDP increases along the production function.

Preconditions for Labour Productivity Growth

• The fundamental precondition for labour productivity growth is the incentive system created by firms, markets, property rights, and money.

• The growth of labour productivity depends on:

  • Physical capital growth

  • Human capital growth

  • Technological advances

Why Labour Productivity Grows - Physical Capital Growth

• The accumulation of new capital increases capital per worker and increases labour productivity.

Why Labour Productivity Grows - Human Capital Growth

• Human capital acquired through education, on-the-job training, and learning-by-doing is the most fundamental source of labour productivity growth.

Why Labour Productivity Grows - Technological Advances

• Technological change—the discovery and the application of new technologies and new goods—has contributed immensely to increasing labour productivity.

Is Economic Growth Sustainable? - We Study Three Growth Theories

• Classical growth theory

• Neoclassical growth theory

• New growth theory

Classical Growth Theory

• Classical growth theory is the view that the growth of real GDP per person is temporary and that when it rises above the subsistence level, a population explosion eventually brings real GDP per person back to the subsistence level.

Modern-Day Malthusians

• Many people today are Malthusians.

• They say that if today’s global population of 7.2 billion explodes to 11 billion by 2050 and perhaps 35 billion by 2300, we will run out of resources, … real GDP per person will decline and we will return to a primitive standard of living.

• We must, say Malthusians, contain population growth.

Is Economic Growth Sustainable? Theories, Evidence, and Policies

• As the population increases the real wage rate falls.

• The population continues to grow until the real wage rate has been driven back to the subsistence real wage rate.

• At this real wage rate, both population growth and economic growth stop.

• Contrary to the assumption of the classical theory, the historical evidence is that population growth rate is not tightly linked to income per person, and population growth does not drive incomes back down to subsistence levels.

Neoclassical Growth Theory

• Neoclassical growth theory is the proposition that real GDP per person grows because technological change induces a level of saving and investment that makes capital per hour of labour grow.

• Growth ends only if technological change stops because of diminishing marginal returns to both labour and capital.

The Neoclassical Theory of Population Growth

• The neoclassical view is that the population growth rate is independent of real GDP and the real GDP growth rate.

Technological Change and Diminishing Returns

• In the neoclassical theory, the rate of technological change influences the economic growth rate but economic growth does not influence the pace of technological change.

• It is assumed that technological change results from chance.

The Basic Neoclassical Idea

• Technology begins to advance at a more rapid pace.

• New profit opportunities arise and investment and saving increase.

• As technology advances and the capital stock grows, real GDP per person increases.

• Diminishing returns to capital lower the real interest rate and eventually economic growth slows and just keeps up with population growth.

• Capital per worker remains constant.

A Problem with Neoclassical Growth Theory

• All economies have access to the same technologies and capital is free to roam the globe, seeking the highest available real interest rate.

• These facts imply that economic growth rates and real GDP per person across economies will converge.

New Growth Theory

• New growth theory holds that real GDP per person grows because of choices that people make in the pursuit of profit and that growth can persist indefinitely.

• The theory begins with two facts about market economies:

  • Discoveries result from choices.

  • Discoveries bring profit and competition destroys profit.

Two Further Facts Play a Key Role in the New Growth Theory

• The two factors:

  • Discoveries are a public capital good.

  • Knowledge is not subject to diminishing returns.

• Increasing the stock of knowledge makes capital and labour more productive.

• Knowledge capital does not experience diminishing returns is the central proposition of new growth theory.

Sorting Out the Theories

• Each theory teaches us something of value but not the whole story.

• Classical theory reminds us that our physical resources are limited and we need technological advances to grow.

• Neoclassical theory emphasizes diminishing returns to capital which means we need technological advances to grow.

• New theory emphasizes the capacity of human resources to innovate at a pace that offsets diminishing returns.

The Empirical Evidence on the Causes of Economic Growth

• Economic growth makes progress through the interplay of theory and empirical evidence.

• Theory makes predictions about what we will observe if it is correct.

• Empirical evidence provides the data for testing the theory.

Policies for Achieving Faster Growth

• Growth accounting tell us that to achieve faster economic growth we must either increase the growth rate of capital per hour of labour or increase the pace of technological change.

• The main suggestions for achieving these objectives are stimulate saving.

Stimulate Saving

• Saving finances investment. So higher saving rates might increase physical capital growth.

• Tax incentives might be provided to boost saving.

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.

• So the market might allocate too few resources to research and development.

• Government subsidies and direct funding might stimulate basic research and development.

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.

Provide International Aid to Developing Countries

• If rich countries give financial aid to developing countries, investment and growth will increase.

• But data on the effect of aid shows that it has had zero or a negative effect.

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.