6. The Long-Run Economic Growth PDF

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ECON 1006 Principles of Economics II (Macroeconomics) Semester 2, 2018/19 The Long-Run Economic Growth 1. Economic Growth • Economists usually define economic growth as an increase in real GDP per capita: o Real GDP per capita = Real GDP/Population. o A measure of living standard. • The real GDP per...

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ECON 1006 Principles of Economics II (Macroeconomics)

Semester 2, 2018/19

The Long-Run Economic Growth 1. Economic Growth •

Economists usually define economic growth as an increase in real GDP per capita: o Real GDP per capita = Real GDP/Population. o A measure of living standard.

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The real GDP per capita growth rates o U.S.: about 1.7% annually since 1980s o China: about 8.6% annually sine 1980s.

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The small difference in the growth rates makes a big difference in long run (compounding): o The rule of 70 (mathematical approximation) shows that the approximate number of years required to double real GDP per capita (or any variable) is 70 divided by the annual growth rate (percentage change in the variable). o Given the stable annual growth rate of 1.7%, U.S. will double its real GDP per capita in 70/1.7 ≈ 41 years. o If China maintains its annual growth rate of 8.6%, it will double its real GDP per capita in 70/8.6 ≈ 8 years.

• What are the sources of sustained economic growth? • Why some economies grow faster than others? 2. The Determinants of Economic Growth •

What are the determinants of real GDP per capita1? Real GDP Total employment Total labor hours Real GDP = × × Population Total labor hours Total employment Population Real GDP = Labor Productivity × Average working hours Population × Employment to Population Ration (EPR)

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Here we measure labor by labor-hours, so it is equivalent to the equation in your textbook. Besides, it is tedious to distinguish average hours as it is relatively stable in most industrialized countries.

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ECON 1006 Principles of Economics II (Macroeconomics)

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Semester 2, 2018/19

The growth equation: %∆ GDP per capita = %∆ Labor Productivity + %∆ Average working hours + %∆ EPR

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Since average working hours are relatively stable, it is not a major determinant of economic growth. Therefore, the two major determinants of economic growth are: o Labor productivity is determined by: ▪ The amounts of other inputs, mainly capital per unit of labor. ▪ The production technology. o

EPR ▪ With a given population, it is determined by the labor market equilibrium.

3. Growth in Employment to Population Ratio (EPR) Real wage (W/P) LS1

LS2

(W/P)

LD2

LD1

Labor (L) Output (Y)

Production Function YF2 YF1

LF1

LF2

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Labor (L)

ECON 1006 Principles of Economics II (Macroeconomics)

Semester 2, 2018/19

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With a given population, greater total employment means an increase in the EPR, and a rise in real GDP per capita.

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In the long run classical model, the total employment is determined by the labor market equilibrium. o What are the factors affecting labor demand and supply?

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What government policies might affect labor demand and supply? o Examples of policies that affect labor supply ▪ Marginal income tax rate ▪ Retirement age ▪ Unemployment benefits reform o

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Examples of policies that affect labor demand ▪ Anything that helps to increase the labor productivity, such as subsidies for education and training ▪ Other policies that may affect the marginal benefits of employing labor such as corporate tax or share of payroll tax contributed by employers

Is raising EPR a way to generate sustained economic growth? o The maximum value of EPR is 1. o EPR may rise and so create economic growth temporarily (while the ERR is rising). But sustained economic growth would require significant, sustained growth in the EPR, which is not realistic.

4. Growth in Productivity (I): The Increase in Capital Stock •

The most important determinant of long-run economic growth is raising labor productivity.

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The major factors affecting labor productivity (supply shocks) are: o The amounts of other inputs, mainly capital per unit of labor. o The production technology

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To understand the determinants of the growth in capital level and its growth, we have to examine how an economy’s capital stock accumulates: The change in capital stock = planned investment – depreciation of existing capital.

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Therefore, for a given rate of capital depreciation and given total employment, the major determinant of the growth in capital stock is planned investment. o In the classical model, the amount of planned investment (hence new capital stock) is determined by the loanable market equilibrium. o What are the factors affecting the demand and supply of loanable funds?

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ECON 1006 Principles of Economics II (Macroeconomics)

Semester 2, 2018/19

Real wage (W/P) LS

(W/P)

LD2 LD1

Labor (L) Output (Y) New Production Function (due to: positive supply shock)

YF2

Production Function

YF1

LF1

•

LF2

Labor (L)

What government policies might affect loanable funds demand and supply? o

Examples of policies that affect the supply of loanable funds (household saving) ▪ Consumption taxes ▪ Capital gain taxes (taxes on the returns on housing saving, i.e. financial investments)

o

Examples of policies that affect the demand for loanable funds ▪ Reduce budget deficit (crowding in effect) • What kind of government spending to cut? o Public investment in infrastructure? ▪ Other policies that may affect the marginal benefits of investment such as corporate profits tax or investment tax credit

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ECON 1006 Principles of Economics II (Macroeconomics)

Semester 2, 2018/19

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Note that it is the capital per unit of labor that affects the labor productivity. o Therefore, given the same EPR and the same amount of investment, a decrease in population growth also raises the growth rate of capital per unit of labor.

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Also so far we have focused on a single other input, physical capital only, but the economy’s other inputs may include human capital. o Human capital refers to the skills and knowledge possessed by labors. o The amount of human capital labor would invest in involves the marginal benefits and marginal costs comparison as in the cases of other input demand. o To increase the investment in human capital, the government should pursue policies that: ▪ reduce the cost of investment in human capital (i.e. interest rate), e.g. providing lowinterest loans ▪ increase the marginal benefits of investment in human capital (i.e. profitability of human capital to households).

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Is increasing capital stock a way to generate sustained economic growth? o Diminishing marginal returns. o Given a fixed depreciation rate, increasing capital stock results in greater amount of capital being depreciated each year. Much of the investment expenditure is used to replace the capital worn out instead adding new capital.

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Developing countries usually start with very low level of capital per worker, so merely capital accumulation could create substantial growth before diminishing returns set in.

5. Growth in Productivity (II): Technological Change •

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Economists generally agree that technology progress is the source of sustained economic growth. o Technological progress refers to the invention and use of new inputs, new outputs, or new methods of production, which results in more output, given the same amount of inputs. Economic growth, especially in developed countries, is mainly based on discovery-based growth (i.e. technological change from new discoveries)

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In developing countries, sustained growth is largely catch-up growth (i.e. besides capital accumulation mentioned, there can be rapid technological change by copying and adapting technologies already in use in rich countries)

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How might government promote technological progress? o Research & Development spending: ▪ Subsidies ▪ Direct spending on R&D o Institutional infrastructure that encourages innovation ▪ Enforcement of property right protection, such as patent (but there may be a counter effect) o International openness that encourages inflow of technology.

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ECON 1006 Principles of Economics II (Macroeconomics)

Semester 2, 2018/19

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Empirical studies show that openness to international trade is good for economic growth2. ▪ Landlocked countries are disadvantaged compared to countries with their own seaports. Legal institutions3

6. Costs of Boosting Economic Growth •

Budgetary cost

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Consumption cost of brute force

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Sacrifice of other social goal, such as income inequalities, hardship for those working in traditional industries.

Consumption Goods ( y)

B

C

Capital Goods (x)

Readings: • Chapter 21

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Sachs and Warner (1995): Among developed nations: the open economies grew at 2.3% per year, while the closed economies grew at 0.7% per year. Among developing nations: the open economies grew at 4.5% per year, while the closed economies grew at 0.7% per year. 3 La Porta, Lopez-de-Silanes, Shleifer and Vishny (1998): Legal protections for shareholders and creditors are stronger in English-style legal systems (such as U.S., Australia, India, Singapore, Hong Kong) than French-style legal systems (such as Italy, Spain and most of the Latin American countries). As a result, the English-style countries have better-developed capital markets. They, in turns, experience more rapid growth because it is easier for small and start-up firms to finance investment projects, leading to more efficient allocation of the nation’s capital.

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