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Why are some nations
rich and others poor?
© 2019 Pearson
Economic Growth
9
CHAPTER CHECKLIST
When you have completed your
study of this chapter, you will be able to
1 Define and calculate the economic growth rate, and
explain the implications of sustained growth.
2 Explain the sources of labor productivity growth.
3 Review the theories of economic growth.
4 Describe policies that speed economic growth.
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9.1 THE BASICS OF ECONOMIC GROWTH
Economic growth is a sustained expansion of
production possibilities measured as the increase in real
GDP over a given period.
Calculating Growth Rates
Economic growth rate is the annual percentage
change of real GDP.
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9.1 THE BASICS OF ECONOMIC GROWTH
To calculate this growth rate, we use the formula:
Real GDP in Real GDP in
current year – previous year
Growth of
real GDP = x 100
Real GDP in previous year
For example, if real GDP in the current year is $8.4
trillion and if real GDP in the previous year was $8.0
trillion, then the growth rate of real GDP is
Growth of $8.4 trillion – $8.0 trillion
real GDP = x 100 = 5 percent.
$8.0 trillion
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9.1 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.
The contribution of real GDP growth to the change in the
standard of living depends on the growth rate of real
GDP per person.
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9.1 THE BASICS OF ECONOMIC GROWTH
We use the above formula to calculate this growth rate,
replacing real GDP with real GDP per person.
Suppose, for example, that in the current year, when real
GDP is $8.4 trillion, the population is 202 million.
Then real GDP per person is $8.4 trillion divided by 202
million, which equals $41,584.
And suppose that in the previous year, when real GDP
was $8.0 trillion, the population was 200 million.
Then real GDP per person in that year was $8.0 trillion
divided by 200 million, which equals $40,000.
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9.1 THE BASICS OF ECONOMIC GROWTH
Use these two values of real GDP per person in the
growth formula to calculate the growth rate of real GDP
per person. It is
Growth rate of real $41,584 – $40,000
= x 100 = 4 percent.
GDP per person $40,000
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9.1 THE BASICS OF ECONOMIC GROWTH
The growth rate of real GDP per person can also be
calculated by using the formula:
Growth of real
= Growth rate of – Growth rate of
GDP per person real GDP population
Growth of 202 million – 200 million
= x 100 = 1 percent.
population 200 million
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9.1 THE BASICS OF ECONOMIC GROWTH
This formula makes it clear that real GDP per person
grows only if real GDP grows faster than the population
grows.
Growth of real
GDP per person = 5 percent – 1 percent = 4 percent.
If the growth rate of the population exceeds the growth
of real GDP, real GDP per person falls.
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9.1 THE BASICS OF ECONOMIC GROWTH
The Magic of Sustained Growth
Sustained growth of real GDP per person can transform
a poor society into a wealthy one. The reason is that
economic growth is like compound interest.
Rule of 70 is the number of years it takes for the level of
any variable to double, which is approximately 70
divided by the annual percentage growth rate of the
variable.
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9.1 THE BASICS OF ECONOMIC GROWTH
Table 9.1 Growth Rates
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9.2 LABOR PRODUCTIVITY GROWTH
What determines the growth rate of real GDP?
The growth rates of the factors of production and the
rate of increase in their productivity.
Real GDP growth contributes to improving our standard
of living.
But our standard of living improves only if we produce
more goods and services with each hour of labor.
So our main concern is to understand what makes labor
more productive.
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9.2 LABOR PRODUCTIVITY GROWTH
Labor Productivity
Labor productivity is the quantity of real GDP produced
by one hour of labor.
It is calculated by using the formula:
Real GDP
Labor productivity =
Aggregate hours
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9.2 LABOR PRODUCTIVITY GROWTH
For example, if real GDP is $8,000 billion and aggregate
hours are 200 billion, then we can calculate labor
productivity as
$8,000 billion
Labor productivity = = $40 per hour.
200 billion
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9.2 LABOR PRODUCTIVITY GROWTH
When labor productivity grows, real GDP per person
grows, so the growth in labor productivity is the basis of
rising living standards.
The growth of labor productivity depends on two things:
• Saving and investment in physical capital
• Expansion of human capital and discovery of new
technologies
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9.2 LABOR PRODUCTIVITY GROWTH
Saving and Investment in Physical Capital
Saving and investment in physical capital increase the
capital per worker and increase labor productivity.
But additional capital will not bring sustained economic
growth because the law of diminishing returns applies
to capital:
If the quantity of capital is small, an increase in capital
brings a large increase in production.
If the quantity of capital is small, an increase in capital
brings a large increase in production.
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9.2 LABOR PRODUCTIVITY GROWTH
Figure 9.1 illustrates the
relationship between
capital and productivity.
The curve PC is the
productivity curve.
1. With a small amount
of capital an increase
in the capital brings a
large increase in real
GDP per hour of
labor.
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9.2 LABOR PRODUCTIVITY GROWTH
2. With a large amount of
capital, an increase in
the capital brings a
small increase in real
GDP per hour of labor.
If capital per hour of labor
keeps increasing, labor
productivity increases by
ever smaller amounts and
eventually stops rising.
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9.2 LABOR PRODUCTIVITY GROWTH
Expansion of Human Capital and Discovery
of New Technologies
Human capital—the accumulated skill and knowledge of
people—comes from three sources:
• Education and training
• Job experience
• Health and diet
Expansion of human capital and the discovery of new
technologies has increased labor productivity.
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9.2 LABOR PRODUCTIVITY GROWTH
The discovery of new technologies have made an even
greater contribution to economic growth than the growth
of human capital.
Combined Influences Bring Labor
Productivity Growth
To reap the benefits of technological change, capital
must increase.
Some of the most powerful technologies are embodied
in human capital, but most technologies are embodied in
physical capital.
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9.2 LABOR PRODUCTIVITY GROWTH
Figure 9.2 illustrates the
effects of increased
human capital and
technological change.
The curve PC0 is the
productivity curve in 1960.
$180 of capital per hour of
labor produced $40 of
goods and services—real
GDP per hour of labor.
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9.2 LABOR PRODUCTIVITY GROWTH
The curve PC1 is the
productivity curve in 2015.
$180 of capital per hour of
labor produced $80 of
goods and services—real
GDP per hour of labor.
The expansion of human
capital and discovery of
new technologies shift the
PC curve upward and are
not subject to diminishing
returns.
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9.2 LABOR PRODUCTIVITY GROWTH
Figure 9.3 illustrates how
labor productivity grows.
In 1960, workers had $80
of capital per hour of labor
and produced $25 of real
GDP per hour of labor.
1. When capital
increased to $180 per
hour of labor in 2015,
real GDP per hour of
labor increased to $40.
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9.2 LABOR PRODUCTIVITY GROWTH
2. The expansion of
human capital and
discovery of new
technologies shifted
the productivity curve
upward to PC1 in
2015 and …
increased real GDP
per hour of labor to
$80.
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9.2 LABOR PRODUCTIVITY GROWTH
Real GDP grows because labor becomes more
productive and also because the quantity of labor
increases.
Figure 9.4 summarizes the sources of real GDP growth.
Real GDP growth depends on quantity of labor growth and
on labor productivity growth.
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9.2 LABOR PRODUCTIVITY GROWTH
Quantity of labor growth depends on
• Population growth
• The labor force participation rate
• Average hours per worker
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9.2 LABOR PRODUCTIVITY GROWTH
Labor productivity growth depends on
• Physical capital growth
• Human capital growth
• Technological advances
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9.3 ECONOMIC GROWTH THEORIES: OLD AND NEW
Old Growth Theory
Classical growth theory is the theory that the clash
between an exploding population and limited resources
will eventually bring economic growth to an end.
Malthusian theory is another name for classical growth
theory—named for Thomas Robert Malthus.
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9.3 ECONOMIC GROWTH THEORIES: OLD AND NEW
The Basic Idea
Advances in technology and the accumulation of capital
bring increased productivity and increased real GDP per
person.
Classical growth theory says that the increase in real
GDP per person will be temporary because prosperity
will induce a population explosion.
The population explosion will decrease real GDP per
person.
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9.3 ECONOMIC GROWTH THEORIES: OLD AND NEW
New Growth Theory
New growth theory is that our unlimited wants will lead
us to ever greater productivity and perpetual economic
growth.
According to new growth theory, real GDP per person
grows because of the choices people make in the pursuit
of profit.
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9.3 ECONOMIC GROWTH THEORIES: OLD AND NEW
Choices and Innovation
The new theory of economic growth emphasizes three
facts about market economies:
• Human capital grows because of choices.
• Discoveries result from choices.
• Discoveries bring profit, and competition destroys profit.
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9.3 ECONOMIC GROWTH THEORIES: OLD AND NEW
Human Capital Expansion and Choices
People decide how long to remain in school, what to
study, and how hard to study.
Discoveries and Choices
The pace at which new discoveries are made—and at
which technology advances—is not determined by
chance.
The pace at which new discoveries are made depends
on how many people are looking for a new technology
and how intensively they are looking.
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9.3 ECONOMIC GROWTH THEORIES: OLD AND NEW
Discoveries and Profits
The forces of competition squeeze profits, so to increase
profit, people constantly seek either lower cost methods
of production or new and better products for which
people are willing to pay a higher price.
Two other facts play a key role in the new growth theory:
• Many people can use discoveries at the same time.
• Physical activities can be replicated.
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9.3 ECONOMIC GROWTH THEORIES: OLD AND NEW
Figure 9.5 illustrates new
growth theory in terms
of a perpetual motion
machine.
1. People want a
higher standard
of living and are
spurred by ...
2. Profit incentives to
make the ...
3. Innovations that lead to ...
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9.3 ECONOMIC GROWTH THEORIES: OLD AND NEW
4. New and better
techniques and
new and better
products, which
in turn lead
to ...
5. The birth of
new firms and
the death of
some old firms,
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9.3 ECONOMIC GROWTH THEORIES: OLD AND NEW
6. New and
better jobs,
and ...
7. More leisure
and more
consumption
goods and
services.
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9.3 ECONOMIC GROWTH THEORIES: OLD AND NEW
The result is ...
8. A higher
standard of
living.
But people want a
yet higher standard
of living, and the
growth process
continues.
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9.3 ECONOMIC GROWTH THEORIES: OLD AND NEW
Economic Growth and the Distribution of
Income
Does the gap between high and low incomes widen or
narrow as real GDP grows?
And what determines the long-term level and trends of
income inequality?
Simon Kuznets showed that between 1880 and 1950,
the top 5 percent’s share of total income shrank from 31
percent to 20 percent in America and from 46 percent to
24 percent in Britain.
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9.3 ECONOMIC GROWTH THEORIES: OLD AND NEW
The Data
Starting in the early 1980s, income inequality increased
in a process that has been called the Great Divergence.
The share of total income received by the top 1 percent
of Americans moved up from 8 percent in 1980 to
18 percent in 2014.
The Great Divergence is the reverse of the Great
Compression that preceded it.
From 1913 to 1980, the income share of the top 1
percent decreased from 18 percent to 8 percent.
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9.3 ECONOMIC GROWTH THEORIES: OLD AND NEW
The Explanation
Kuznets: Market forces in a dynamic economy create
income growth.
Everyone is free to create a business. Some succeed
and some fail. A greater number of hungry low-income
entrepreneurs succeed than do rich ones, so inequality
shrinks.
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9.3 ECONOMIC GROWTH THEORIES: OLD AND NEW
Paul Krugman says the Kuznets explanation of a
compression does not fit the timing.
Krugman: Progressive income taxation, a strengthening
of labor unions, and World War II wage and price
controls created the compression.
But timing poses a problem for Krugman’s policy
induced explanation …. the largest convergence
occurred in the late 1930s, well before the political
events that are claimed to have caused it.
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9.3 ECONOMIC GROWTH THEORIES: OLD AND NEW
Krugman: Great Divergence was caused by lower taxes
on the rich, erosion of welfare programs, a decline in
union membership, and soaring executive pay.
Piketty: Great Divergence arises from the relationship
between the interest rate, r, and the growth rate, g.
The wealthy get income from capital, which grows at r.
Others get income from labor, which grows at g.
Because r > g, the incomes of the rich grow faster than
everyone else’s income.
For Piketty, no automatic mechanism works against the
steady concentration of wealth.
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9.3 ECONOMIC GROWTH THEORIES: OLD AND NEW
Economists do not yet have sound answers to the
questions Simon Kuznets posed 60 years ago.
We don't know enough to say where inequality is
heading.
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9.4 ACHIEVING FASTER GROWTH
Preconditions for Economic Growth
Economic freedom is the fundamental precondition for
creating the incentives that lead to economic growth.
Economic freedom is a condition in which people are
able to make personal choices, their private property is
protected, and they are free to buy and sell in markets.
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9.4 ACHIEVING FASTER GROWTH
Economic freedom requires the protection of private
property—the factors of production and goods that
people own.
Property rights are the social arrangements that govern
the protection of private property.
Economic freedom also requires free markets.
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9.4 ACHIEVING FASTER GROWTH
Policies to Achieve Faster Growth
To achieve faster economic growth, we must increase
• The growth rate of capital per hour of labor or
• The growth rate of human capital or
• The pace of technological advance.
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9.4 ACHIEVING FASTER GROWTH
The main actions that governments can take to achieve
these objectives are
• Create incentive mechanisms
• Encourage saving
• Encourage research and development
• Encourage international trade
• Improve the quality of education
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9.4 ACHIEVING FASTER GROWTH
Create Incentive Mechanisms
Economic growth occurs when the incentive to save,
invest, and innovate is strong enough. These incentives
exist only when private property is protected.
Encourage Saving
Saving finances investment, which brings capital
accumulation.
Tax incentives can encourage saving, increase the
growth of capital, and stimulate economic growth.
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9.4 ACHIEVING FASTER GROWTH
Encourage Research and Development
Everyone can use the fruits of basic research and
development efforts.
Because basic inventions can be copied, the inventor’s
profit is limited and so the market allocates too few
resources to this activity.
Governments can direct public funds toward financing
basic research, but it requires a mechanism for
allocating public funds to their highest-valued use.
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9.4 ACHIEVING FASTER GROWTH
Encourage International Trade
Free international trade stimulates economic growth by
extracting all the available gains from specialization and
trade.
Improve the Quality of Education
By funding basic education and by ensuring high
standards in skills such as language, mathematics, and
science, governments can contribute enormously to a
nation’s growth potential.
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9.4 ACHIEVING FASTER GROWTH
How Much Difference Can Policy Make?
A well-intentioned government cannot dial up a big
increase in the growth rate.
But it can pursue policies that will nudge the growth rate
upward.
And over time, the benefits from these policies will be
large.
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Political stability, property rights protected by the rule of law,
limited government intervention in markets are the key
features of the economies that enjoy high incomes …
and they are the features missing in those that remain poor.
Most of the rich nations have experienced sustained
economic growth over many decades.
Europe’s Big 4 economies (France, Germany, Italy, and the
United Kingdom) have been enjoying economic growth for
200 years.
The United States started to grow rapidly 150 years ago
and overtook Europe in the early 20th century.
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In the past 50 years,
the gaps between
these countries
haven’t changed
much.
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Real GDP per person
in three Asian
economies has
converged toward that
in the United States.
These economies are
like fast trains running
on the same track at
similar speeds with
roughly constant gaps.
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Between 1960 and
2015, Hong Kong
and some other
Asian economies
transformed
themselves from
poor developing
economies to take
their places among
the world’s richest
economies.
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