Chapter 7: Economic Growth: Theory and Policy

Growth Policy

ensuring that the economy sustains a high long-run growth rate of potential GDP (although not necessarily the highest possible growth rate)

Stabilization Policy

keeping actual GDP reasonably close to potential GDP in the short run, so that society is plagued by neither high unemployment nor high inflation

As we learned in the previous chapter, the growth rate of potential GDP is the

is the sum of the growth rates of hours of work and labor productivity.

Human Capital

is the amount of skill embodied in the workforce. It is most commonly measured by the amount of education and training

In consequence, the natural focus of growth policy is on enhancing productivity—on working

smarter rather than working harder.

three main determinants of productivity growth:

The rate at which the economy builds up its stock of capital

The rate at which technology improves

THREE PILLARS OF Productivity Growth

1) CAPITAL

- for a given technology and a given labor force, labor productivity will be higher when the capital stock is larger

2) TECHNOLOGY

- for given inputs of labor and capital, labor productivity will be higher when the technology is better

3) LABOR QUALITY: EDUCATION AND TRAINING

- for a given capital stock, labor force, and technology, labor productivity will be higher when the workforce has more education and training

CAPITAL

-

for a given technology and a given labor force, labor productivity will be higher when the capital stock is larger

TECHNOLOGY

-

for given inputs of labor and capital, labor productivity will be higher when the technology is better

Levels, Growth Rates, and the Convergence Hypothesis

The level of productivity in a nation depends on its supplies of human and physical capital and the state of its technology. But the growth rate of productivity depends on the rates of increase of these three factors (capital stock, technology, educational attainment)

- when it comes to determining the long run growth rate, it is the growth rates rather than the current levels of these three pillars that matter

LABOR QUALITY: EDUCATION AND TRAINING

-

for a given capital stock, labor force, and technology, labor productivity will be higher when the workforce has more education and training

For given inputs of labor and capital, labor productivity

will rise as technology improves.

For a given capital stock, labor force, and technology, labor productivity will rise as the

the workforce acquires more education and training.

When we say that a nation's technology improves, we mean, more or less, that its firms can produce

more output from the same inputs.

Notice that where productivity growth rates are concerned,

it is the rates of increase of capital, technology, and workforce quality that matter, rather than their current levels.

But the growth rates of capital, workforce skills, and technology are not necessarily higher

higher in the rich countries.

The level of productivity in a nation depends on its

supplies of human and physical capital and the state of its technology.

the growth rate of productivity depends on the

rates of increase of these three factors.

f the productivity growth rate is higher in poorer countries than in richer ones,

hen poor countries will close the gap on rich ones.

Productivity levels are vastly

higher in the rich countries—that is why they are called rich. The wealthy nations have more bountiful supplies of capital, more highly skilled workers, and superior technologies. So naturally, they produce more output per hour of work.

three principal determinants of a nation's productivity growth rate:

The rate at which the economy builds up its stock of capital

The rate at which technology improves

The rate at which workforce quality (or "human capital") improves

Convergence Hypothesis

the productivity growth rates of poorer countries tend to be higher than those of richer countries

- The shrinking gap between the income levels of poor and rich countries

- main reason to expect convergence in the long run is that low-productivity countries should be able to learn from high-productivity countries (simply by imitating -> look it up, and create it), whereas high-productivity countries can improve its technology only by innovating

- UNFORTUNATELY, some of the world's poorest nations have been unable to join the club (by imitating)

Technological laggards can, and sometimes do, close the gap with technological leaders by imitating and adapting existing technologies. Within this "convergence club,"

productivity growth rates are higher where productivity levels are lower. Unfortunately, some of the world's poorest nations have been unable to join the club.

Capital

a nations capital is its available supply of plant, equipment, and software. It is the result of past decisions to make investments in these items

Investment

is the flow of resources into the production of new capital. It is the labor, steel, and other inputs devoted to the construction of factories, warehouses, railroads, and other pieces of capital during some period of time

Capital Formation

is synonymous with investment. It refers to the process of building up the capital stock

The production possibilities frontier introduced in Chapter 3 can be used to depict the nature of this trade-off—a

and the choices open to a nation. Given its technology and existing resources of labor, capital, and so on, the country can, in principle, select any point on the production possibilities frontier

But you don't get something for nothing. Devoting more of society's resources to producing investment goods generally means devoting fewer resources to producing consumer goods.

Real Interest Rates

when real interest rates fall, investment normally rises BECAUSE businesses often borrow to finance their investments, and the real interest rate indicates how much firms must pay for that privilege (they don't have to pay as much interest; therefore, investment is higher)

- the amount that businesses invest depends on the real interest rate they pay to borrow funds. the lower the real rate of interest, the more investment there will be

The amount that businesses invest depends on the

real interest rate they pay to borrow funds. The lower the real rate of interest, the more investment there will be.

The tax law

gives the government several ways to influence business spending on investment goods, but influence is far from control. Business decisions are dominant in capital formation, and these decisions depend on many factors other than taxes.

What Drives Investment?

1) Tax Provisions

- the tax law gives the government several ways to influence business spending on investment goods, but influence is far from control. business decisions are dominant in capital formation, and these decisions depend on many factors other than taxes

2) Technical Change

- new business opportunities suddenly appear when a new product such as the smart phone is invented or when a technological breakthrough makes an existing product much cheaper or better -> building new factories, stores, and offices, and buying new equipment

3) The Growth of Demand

- high levels of sales and expectations of rapid economic growth create an atmosphere conducive to investment

4) Political Stability and Property Rights

- construction costs might run higher than estimated

- interest rates might rise

- demand for product might prove weaker than expected

High levels of sales and expectations of rapid economic growth create an

tmosphere conducive to investment.

Property Rights

are laws and/or conventions that assign owners the rights to use their property as they see fit (within the law) - for example, to sell the property or to reap the benefits (such as rents or dividends) while they own it

On-The-Job Training

refers to skills that workers acquire while at work, rather than in school or in formal vocational training programs

Invention

is the act of discovering new products or new ways of making products

Innovation

is the act of putting new ideas into effect, for example, by bringing new products to market, changing product designs, and improving the way in which things are done

High levels of education,

especially scientific, engineering, and managerial education, contribute to the advancement of technology.

High rates of investment contribute to r

rapid technical progress.

Research and Development (R&D)

refers to activities aimed at inventing new products or processes, or improving existing ones

Growth Policy: Spurring Technological Change

1) More Higher Education

- high levels of education, especially scientific, engineering, and managerial education, contribute to the advancement of technology

2) More Capital Formation

- high rates of investment contribute to rapid technical progress

3) Research and Development

- a more direct way to spur invention and innovation

Cost Disease of the Personal Services

service activities that require direct personal contact tend to rise in price relative to other goods and services

Growth in the Developing Countries

1) Capital (Development Assistance, foreign direct investment, multinational corporation)

- poorly endowed with capital -> low incomes -> unable to accumulate volumes of business capital (factories, equipment) and public capital (roads, bridges, airports, and so on)

2) Technology

- poor countries can just adopt technologies that have already been invented in the rich countries

ex: japan, south korea, singapore, china

3) Education and Training

U.S. = 12.3 years

INDIA = less that 5 years

SUDAN = 2 years

Development Assistance (foreign aid)

refers to outright grants and low-interest loans to poor countries from both rich countries and multinational institutions like the World Bank. The purpose is to spur economic development.

Foreign Direct Investment

is the purchase or construction of real business assets - such as factories, offices, and machinery - in a foreign country

Multinational Corporations

are corporations, generally large ones, that do business in many countries. Most, but not all, of these corporations have their headquarters in developed countries

Productivity Slowdown (1973-1995)

1) Lagging Investment (lack of investment in america)

2) High Energy Prices (OPEC jacked up the price of oil due to war)

3) Inadequate Workforce Skills (U.S. labor force failed to keep pace with the demands o new technology)

4) A Technological Slowdown?

Productivity Speed-up (since 1995)

1) Surging Investment

2) Falling Energy Prices?

3) Advances in Information Technology

Surging Investment

Bountiful new business opportunities in the IT sector and elsewhere, coupled with a strong national economy, led to a surge in business investment spending in the 1990s. Business investment rose sharply as a percentage of real GDP from 1995 to 2000, and most of the increase was concentrated in computers, software, and telecommunications equipment. We have observed several times in this chapter that the productivity growth rate should rise when the capital stock grows faster, and that's exactly what happened in the late 1990s. But then investment fell after the stock market crashed in 2000. Over the entire 1995-2010 period, the table in the "Growth Accounting in the United States" box shows only a slightly larger contribution of capital formation to productivity growth than over 1973-1995. So investment is only a small part of the answer.

Falling Energy Prices?

For part of this period, especially the years 1996-1998, energy prices were falling. By the same logic used earlier, falling energy prices should have enhanced productivity growth. But, as we noted earlier, this argument did not seem to work so well when energy prices fell in the 1980s. Why, then, should we believe it for the 1990s? In addition, productivity continued to surge in the early years of this decade, as energy prices soared.

The biggest pillar of productivity growth

technological change—seems to do most of the work of explaining why productivity accelerated in the United States after 1995.

From Long Run to the Short Run

Long-Run Theory of Aggregate Supply (Economic Growth)

Short-Run Theory of Aggregate Demand (GDP)

From the Long Run to the Short Run

Most of this chapter has been devoted to explaining and evaluating the factors underpinning the growth rate of potential GDP. Over long periods of time, the growth rates of actual and potential GDP match up pretty well. But, just like people, economies do not always live up to their potential. As we observed in the previous chapter, GDP in the United States often diverges from potential GDP as a result of macroeconomic fluctuations. Sometimes it is higher; sometimes, as in the years after the Great Recession, it is lower. Indeed, whereas this chapter has studied the factors that determine the rate at which the GDP of a particular country can grow from one year to the next, we were reminded after 2007 that GDP occasionally shrinks—during periods we call recessions. To study these fluctuations, we must supplement the long-run theory of aggregate supply, which we have just described, with a short-run theory of aggregate demand—a task that begins in the next chapter.

The cost disease of personal services

is the tendency of the costs and prices of personal services to rise persistently faster than those of the average output in the economy.

Development assistance

("foreign aid") refers to outright grants and low-interest loans to poor countries from both rich countries and multinational institutions like the World Bank. The purpose is to spur economic development.

Foreign direct investment

is the purchase or construction of real business assets—such as factories, offices, and machinery—in a foreign country.

Multinational corporations

are corporations, generally large ones, that do business in many countries. Most, but not all, of these corporations have their headquarters in developed countries.

Two crucial tasks for macroeconomic policymakers•

Growth Policy• Sustain a high long-run growth rate of potential GDP• Not necessarily the highest possible growth rate• Stabilization policy• Keeping actual GDP reasonably close to potential GDP in the short run• Avoid high unemployment and high inflation

Growth rate in potential GDP =

growth rate of hours of work +• growth in labor productivity• focus of growth policy is on improving productivity

What are the determinants of labour productivity?

Rate at which the economy builds up its stock of capital• Rate at which technology improves• The rate at which workforce quality improves

Productivity levels versus productivity growth rates

Levels higher in rich countries since they have more capital, more highly killed workers,and better technology• Growth rates are not necessarily higher in rich countries

The level of productivity depends on•

Supplies of human and physical capital and technology•

The growth rate of productivity depends on•

The rates of increase of these three factors• Why is the distinction important?• If growth rates in poorer countries are higher than in rich ones, the poor countries willclose the gap on rich ones

Convergence hypothesis•

The productivity growth rates of poorer countries tend to be higher than those of richercountries• Therefore, over time, the gap between the two countries should close

Why would we expect convergence to be the norm?•

Low productivity countries can learn from high productivity countries• Rich countries on the technological frontier so need to innovate• Poor countries can imitate• Benefits of modern communication• But many poor countries unable to converge

Technological laggards

Some countries have closed the gap with tech leaders by imitating and adapting existingtechnologies• "Convergence club"• Productivity growth rates are higher where productivity levels are lower• But some nations unable to join the club

How the government might spur growth by working on the three pillars of growth?•

Capital• Available supply of plant, equipment, and software• Result of past decisions to make investments in these items• Growth in capital stock or capital formation depends on investment• Flow of resources into the production of new capital• Labor, steel, and other inputs devoted to the construction of factories, warehouses,railroads, and other pieces of capital during some period of time

Sounds easy• More investment in capital leads to higher growth rates in labor productivity•

Higher standards of living• But always remember there are tradeoffs• More investment in capital means less resources for consumptionGrowth Policy: Encouraging Capital Formation 2 of 5

How can the government persuade private businesses to invest more?•

Real interest rate• The lower (higher) the real interest rate, the more (less) investment• The role of monetary policy• Tax provisions•

Technical change• New products, cheaper and better products lead to capital formation• Growth of demand• As demand presses on capacity, new factories can be employed profitably• High levels of sales and expectations of rapid economic growth can lead to moreinvestment

Political stability and property rights• Property rights are laws that assign owners the rights to use their property as they see fit• Strong rule of law, low levels of corruption etc.• Provide support for long term investment projects• Failure of the rule of law in poor economies

Tax provisions•

Influence investment decisions by changing the tax code• Tax write-offs for investment in equipment• Reduce capital gains taxGrowth Policy: Encouraging Capital Formation 3 of 5

How can the government improve education and training?•

Education policies• Raise rates of high school attendance and completion• Improve the quality of secondary education• Sending more people to college and graduate school• Wage premium for college graduates

Besides education, what else may improve labor productivity?•

On the job training• Skills that workers acquire while at work, rather than in school or in formal vocationaltraining programs

Expanding higher education•

More innovation with greater supply of scientists, engineers, skilled managers• Will the U.S. education leadership continue?•

More capital formation•

High rates of capital formation lead to faster technological progress

Government policies to provide R&D incentives•

Subsidizes private R&D spending with tax incentives• Joint ventures with private companies (Human Genome Project)• Government agencies financed by taxes (NIH, NSF

The Productivity Slowdown: 1973-1995•

lagging investment

high energy prices

inadequate workforce skills

technological slowdown