Long-Run Economic Growth

Long-Run Economic Growth

Potential GDP: The level of GDP attained when all firms are producing at capacity.

Business cycle: Alternating periods of economic expansion and economic recession.

Comparing Economies

• Economists measure growth using Real GDP and perhaps more importantly Real GDP per capita (GDP per person).

• Real GDP per capita is five times the 1929 level, and 7 times the 1900 level

Real GDP in Year 2 - Real GDP in Year 1Growth in Real GDP = x100

Real GDP in Year 1

Example: Compare across countries

Country 2007 Real GDP (billions)

2008 Real GDP (billions)

Brazil $1,295.7 $1,362.6

Mexico $8,806.7 $8,911.4

Thailand $4,259.5 $4,368.4

Question: What country experienced the highest growth rate in 2008? The lowest?

Example: Country AYear Real GDP per capita (2005 prices)

2006 $41,552

2007 $42,680

2008 $42,202

2009 $43,194

2010 $43,102

a. What is the % increase in real GDP per capita between 2006 and 2010?

b. What is the average annual real GDP per capita growth rate between 2006 and 2010?

Long-Run Economic Growth

Long-run economic growth: The process by which rising productivity increases the average standard of living.

Growth Rates

• How did the United States produce seven times more real GDP per capita in 2000 than in 1900?

• A little bit at a time – power of compounding!

• Long-run economic growth is normally a gradual process, in which real GDP per capita grows at most a few percent per year.

Why Do Growth Rates Matter?

Growth rates matter because an economy that grows too slowly fails to raise living standards.

In the long run, small differences in economic growth rates result in big differences in living standards.

Small Differences in Growth Rates Are Important

Rule of 70

• During the twentieth century, real GDP per capita in the United States increased an average of 1.9% each year.

• The years it takes for a variable that grows gradually to double is approximately:

Rule of 70

• So at 1.9% growth, how long does it take real GDP per capita to double?– ANSWER: 37 Years (approx.)

• So if it takes 37 years to double, how many years to be 8 times as large?– ANSWER: Doubling 3 Times = 2 x 2 x 2 = 8– So it takes 3 x 37 years = 111 years

Sources of Long-Run Growth

• Labor productivity, often referred to simply as productivity, is output per worker (usually one worker by one hour of work).

• Physical capital consists of human-made resources such as buildings and machines.

• Human capital is the improvement in labor created by the education and knowledge embodied in the workforce.

• Technology: A change in the quantity of output a firm can produce using a given quantity of inputs.

What Determines How Fast Economies Grow?

• Better machinery and equipment.

• Increases in human capital.

There are three main sources of technological change:

Human capital The accumulated knowledge and skills that workers acquire from education and training or from their life experiences.

• Better means of organizing and managing production.

Accounting for Growth

• Aggregate Production Function: A hypothetical function that shows how real GDP per worker depends on the quantities of physical and human capital per worker as well as technology.

Diminishing Return to Physical Capital

• Aggregate Production Function exhibits diminishing returns to physical capital when:

– holding the amount of human capital and the state of technology fixed

–each successive increase in the amount of physical capital leads to a smaller increase in productivity.

Hypothetical Example

Physical Capital and Productivity

The Per-Worker Production Function

The Per-Worker Production Function

Which Is More Important for Economic Growth: More Capital or Technological Change?

Growth Accounting

• Growth accounting: estimates the contribution of each major factor in the aggregate production function to economic growth.

• Physical capital per worker grows 3% a year.

• According to estimates each 1% rise in physical capital per worker, holding human capital and technology constant, raises output per worker by 0.33%.

Technology and Productivity

Technological Change Increases Output per Hour Worked

What Determines How Fast Economies Grow?Technological Change: The Key to Sustaining Economic Growth

•What Explains the Economic Failure of the Soviet Union?

Makingthe

Connection

The fall of the Berlin Wall in 1989 symbolized the failure of Communism.

A centrally planned economy, such as the Soviet Union’s, could not, over the long run, grow faster than a market economy. The Soviet Union collapsed in 1991, and contemporary Russia now has a more market-oriented system, although the government continues to play a much larger role in the economy than does the government in the United States.

Natural Resources

• In the modern world, natural resources are a much less important determinant of productivity than human or physical capital for the great majority of countries.

• Some nations with very high real GDP per capita, such as Japan, have very few natural resources. Some resource-rich nations, such as Nigeria (which has sizable oil deposits), are very poor.

What Determines How Fast Economies Grow?New Growth Theory

If technological change is the key to growth then what encourages the technological change?

• Protecting intellectual property with patents and copyrights.

Patent: The exclusive right to a product for a period of 20 years from the date the product is invented.

• Subsidizing research and development.

• Subsidizing education.

Government policy can help increase the accumulation of knowledge capital in three ways:

Why Growth Rates Differ

• Countries differ greatly in their growth rates of real GDP per capita, largely due to differences in government policies and institutions that alter:

savings and investment spending foreign direct investmentForeign portfolio investment (new)educationInfrastructure (Roads, power lines, ports, IT networksresearch and development (create/implement tech)political stabilitythe protection of property rights

Political Stability & Property Rights

•Property rights: The rights individuals or firms have to the exclusive use of their property, including the right to buy or sell it.

•Rule of law: The ability of a government to enforce the laws of the country, particularly with respect to protecting private property and enforcing contracts.

Political Stability & Property Rights

•Political stability and protection of property rights are crucial ingredients in long-run economic growth.

There’s not much point in investing in a business if rioting mobs are likely to destroy it or saving your money if someone with political connections can steal it.

Excessive Government Intervention

•Even when governments aren’t corrupt, excessive government intervention can be a brake on economic growth.

If large parts of the economy are supported by government subsidies, protected from imports, or otherwise insulated from competition, productivity tends to suffer because of a lack of incentives.

Poor Countries Regulate Businesses The Most….

Success, Disappointment, and Failure

Success in Economic Growth

East Asian economies have done many things right and achieved very high growth rates.

Savings and Investment SpendingEmphasis on Education Adopting advanced technologyGovernment Stability

Disappointment in Economic Growth

In Latin America, where some important conditions are lacking, growth has generally been disappointing.

Poor educationPolitical InstabilityIrresponsible GovernmentCorruption

Disappointment in Economic Growth

In Africa, real GDP per capita has declined for several decades, although there are some signs of progress now.

Severe Political and Economic InstabilityPoverty ItselfDisease &WarGeographyPoor InfrastructurePublic Health

Convergence Hypothesis

Convergence Hypothesis: International differences in real GDP per capita tend to narrow (converge) over time.

The growth rates of economically advanced countries have converged, but not the growth rates of countries across the world

Factors that affect growth, such as education, infrastructure, and favorable policies and institutions must be held equal across countries.

Convergence?