CHAPTER 24

Economic Growth
After studying this chapter you will be able to

Define and calculate the economic growth rate and

explain the implications of sustained growth
Describe the economic growth trends in the United
States and other countries and regions
Identify the main sources of economic growth
Explain how we measure the effects of the sources of
economic growth and identify why growth rates fluctuate
Explain the main theories of economic growth

2
Transforming People’s Lives

Real GDP per person in the United States almost tripled

between 1960 and 2005.
What causes the growth in production, income, and living
standards?
Elsewhere, notably in China and other parts of Asia, growth
is even faster; and technology 2,000 years old coexists with
the most modern.
Why are incomes in Asia growing so fast?
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.
The Basics of Economic Growth

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.
The Basics of 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.
The Basics of Economic Growth

Applying the Rule of 70

Figure 24.1 show the

doubling time for growth
rates.
A variable that grows at
2 percent a year
doubles in 35 years.
A variable that grows at
7 percent a year
doubles in 10 years.
Economic Growth Trends

Growth in the U.S. Economy

From 1905 to 2005, growth in real GDP per person in the
United States averaged 2 percent a year.
Real GDP per person fell precipitously during the Great
Depression and rose rapidly during World War II.
The growth rate was greater after World War II than it was
before the Great Depression.
Figure 24.2 on the next slide illustrates.
Economic Growth Trends
Economic Growth Trends
Real GDP Growth in the
World Economy

Figure 24.3(a) shows the

growth in the rich countries.
Japan grew rapidly in the
1960s, slower in the 1980s,
and even slower in the
1990s.
Growth in Europe Big 4,
Canada, and the United
States has been similar.
Economic Growth Trends

Figure 24.3(b) shows

the growth of real GDP
per person in group of
poor countries.
The gaps between real
GDP per person in the
United States and in
these countries have
widened.
Economic Growth Trends
Figure 24.4 shows growth
in Asian economies.
China is growing very
rapidly.
Other formerly low-income
economies—Korea,
Taiwan, Singapore, and
Hong Kong are examples
—have grown very rapidly
and
have caught up or are
catching up with the United
States.
The Sources of Economic Growth

Real GDP growth contributes to improvements in our

standard of living.
But our standard of living improves only if we produce
more goods and services.
We begin by dividing real GDP growth into the forces that
increase:
 Aggregate hours
 Labor productivity
The Sources of Economic Growth

Aggregate Hours
Aggregate hours, the total number of hours worked by all
the people employed, change as a result of:
1. Working-age population growth
2. Changes in the employment-to-population ratio
3. Changes in average hours per worker
Population growth increases aggregate hours and real
GDP, but to increase real GDP person, labor must
become more productive.
The Sources of Economic Growth

Labor Productivity
Labor productivity is the quantity of real GDP produced
by an hour of labor; it equals real GDP divided by
aggregate hours.
The growth of labor productivity depends on
 Physical capital growth
 Human capital growth
 Technological advances
The Sources of Economic Growth

Physical Capital Growth

Physical capital growth results from saving and investment
decisions.
The accumulation of new capital increased capital per
worker and increased labor productivity.
Human Capital Growth
Human capital acquired through education, on-the-job
training, and learning-by-doing is the most fundamental
source of economic growth.
It is the source of increased labor productivity and
technological advance.
The Sources of Economic Growth

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

Figure 24.5 on the next slide summarizes the process of

growth.
It also shows that the growth of real GDP per person
depends on real GDP growth and the population growth
rate.
The Sources of Economic Growth
The Sources of Economic Growth

Preconditions for Economic Growth

The basic precondition for economic growth is an
appropriate incentive system.
Three institutions are crucial to the creation of the proper
incentives:
1. Markets
2. Property rights
3. Monetary exchange
Growth Accounting

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.
The purpose of growth accounting is to calculate how
much real GDP growth results from the growth of labor
and capital and how much is attributable to technological
change.
Growth Accounting

The identify the contribution of capital growth to real GDP

growth, we need to know labor productivity changes when
the quantity of capital changes.
The law of diminishing returns states:
As the quantity of one input (capital) increases with the
quantities of all other inputs (labor hours and technology)
remaining the same, output increases but in ever smaller
increments.
But how much smaller are the increments?
The answer is given by the one third rule.
Growth Accounting

Robert Solow discovered that diminishing returns are well

described by the one-third rule:
With no change in technology, on the average, a 1 percent
increase in capital per hour of labor brings a 1/3 percent
increase in labor productivity (real GDP per hour of labor).
For example, suppose capital per hour of labor grows by 3
percent and labor productivity grows by 2.5 percent.
The one third rule tells us that capital growth contributed
1/3 of 3 percent, which is 1 percent, to labor productivity
growth.
Human capital growth and technological change
contributed the other 1.5 percent.
Growth Accounting

Accounting for the Productivity Growth Slowdown and

Speedup
We can use the one third rule to study productivity growth
in the United States.
Figure 24.6 on the next slide illustrates.
Growth Accounting
Part (a) shows the growth of
U.S. labor productivity
Booming Sixties
Between 1960 and 1973,
labor productivity grew by
3.7 percent a year.
Capital growth (green bar)
and technological change
and growth of human
capital (purple bar)
contributed equally to this
growth.
Growth Accounting

Slowdown
Between 1973 and 1983,
labor productivity slowed to
1.7 percent a year.
A collapse in the contribution
of technological change and
human capital and (purple
bar) brought about this
slowdown in the growth of
labor productivity.
Growth Accounting
Speedup
Labor productivity growth
rate increased to 2 percent
a year between 1983 and
1993 and to 2.4 percent
between 1993 and 2005.
Technological change and
growth of human capital
contributed most to this
speedup in the growth of
labor productivity.
Growth Accounting
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 labor or increase the pace of technological
change.
The main suggestions for achieving these objectives are
Stimulate Saving
Saving finances investment. So higher saving rates might
increase physical capital growth.
Tax incentives might be provided to boost saving.
Growth Accounting

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.
Growth Accounting

Target High-Technology Firms

The suggestion is that by subsidizing high-technology
industries, a nation can enjoy a temporary advantage over
its competitors.
This is a very risky strategy because it is unclear that
government is better at picking winners than the profit-
seeking entrepreneurs.
Growth Accounting

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.
Growth Theories
Real GDP increases if
1. The economy recovers from a recession.
2. Potential GDP increases.
Economic growth is the sustained increase in potential
GDP.
Two factors that increase potential GDP are
 An increase in labor productivity
 An increase in population
Growth Theories

An Increase in Labor Productivity

Three factors increase labor productivity:
 An increase in physical capital
 An increase in human capital
 An advance in technology
An increase in labor productivity shifts the production
function upward and increases the demand for labor.
The equilibrium real wage rate, quantity of labor, and
potential GDP all increase.
Growth Theories

Figure 24.7(a) shows the

change in potential GDP.
The increase in labor
productivity shifts the
production function
upward.
Growth Theories

Figure 24.7(b) illustrates

these effects in the labor
market.
An increase in labor
productivity increases the
demand for labor.
With no change in the
supply of labor, the real
wage rate rises
and aggregate hours
increase.
Growth Theories

And with the increase in

aggregate hours, potential
GDP increases.
Growth Theories

An Increase in Population
An increase in population increases the supply of labor.
With no change in the demand for labor, the equilibrium
real wage rate falls and the aggregate hours increase.
The increase in the aggregate hours increases potential
GDP.
Growth Theories

Figure 24.8(a) illustrates

these effects in the labor
market.
The labor supply curve
shifts rightward.
The real wage rate falls
and aggregate hours
increase.
Growth Theories

The increase in aggregate

hours increases potential
GDP.
Because the marginal
product of labor
diminishes, the increased
population increases real
GDP but decreases real
GDP per hour of labor.
Growth Theories

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.
Growth Theories

Classical Theory of Population Growth

There is a subsistence real wage rate, which is the
minimum real wage rate needed to maintain life.
Advances in technology lead to investment in new capital.
Labor productivity increases and the real wage rate rises
above the subsistence level.
When the real wage rate is above the subsistence level, the
population grows.
Population growth increases the supply of labor and brings
diminishing returns to labor.
Growth Theories

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.
Growth Theories

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 labor grow.
Growth ends only if technological change stops.
Growth Theories

The Neoclassical Economics 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
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.
Growth Theories

Target Rate of Return and Saving

The key assumption in the neoclassical growth theory
concerns saving.
Other things remaining the same, the higher the real
interest rate, the greater is the amount that people save.
To decide how much to save, people compare the rate of
return with a target rate of return.
If the rate of return exceeds the target rate of return,
saving is sufficient to make capital per hour of labor grow.
Growth Theories

If the rate of return is less than the target rate of return,

saving is not sufficient to maintain the current level of
capital per hour of labor, so capital per hour of labor
shrinks.
And if the rate of return equals a target rate of return,
saving is just sufficient to maintain the quantity of capital
per hour of labor at its current level.
Growth Theories

The Basic Neoclassical Idea

Technology begins to advance more rapidly.
New profit opportunities arise.
Investment and saving increase.
As technology advances and the capital stock grows, real
GDP per person rises.
Diminishing returns to capital lower the real interest rate
and eventually growth stops, unless technology keeps on
advancing.
Growth Theories

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:
 In a market economy, discoveries result from choices.
 Discoveries bring profit and competition destroys profit.
Growth Theories

Two further facts play a key role in the new growth theory
are
 Discoveries are a public capital good.
 Knowledge is not subject to diminishing returns.
Knowledge Capital Is Not Subject to Diminishing
Returns
Increasing the stock of knowledge makes capital and labor
more productive. The fact that knowledge capital does not
experience diminishing returns is the central proposition of
new growth theory.
Growth Theories

Figure 24.9
summarizes
the ideas of
new growth
theory as a
perpetual
motion
machine.
THE END