Module 4

Three Main Macroeconomic Variables:

Long-Run Economic Growth
 Economic growth since 1 million B.C.E.
There was very little progress for most of
human history.
 Hand-to-mouth as hunters and
gatherers.
 Transitioned to farming, but starvation
and malnutrition were still common.
From 1 million B.C.E. until 1200 C.E., GDP per
person was around $200 per year.
At the start of the 1800s, world real GDP
per person was roughly $400 per year.
TAHA JAWASHI/AFP/Getty Images

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Economic growth over the past two centuries (1 of 2)

PHAS/Universal Images Group/Getty Images

Agricultural advances and the Industrial Revolution created more food, and acted as an engine
of economic growth:
 Crop rotation, higher-yield crops, new farm equipment, and transportation infrastructure meant
fewer resources needed to grow food.
 Revolutionary new products: steam engine, sewing machine, light bulb, telephone.
 People can produce more than ever before!
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Economic growth over the past two centuries (2 of 2)

From 1200 to 1800, it took 600 years

for worldwide real GDP to double, but
then growth exploded:
 More than doubled by 1900.
 Doubled again by 1950.
 Doubled again by 1975.
 Doubled again by early 2000s.
Left: Vachon, John, Library of Congress LC-USW3-022930-D
 Doubled again by 2020.
4 Peter Tsai Photography/Alamy
Right: Macmillan Learning, ©2023
 Why Is Economic Growth Important?
• A 1 percent change in annual growth Hypothetical GDP Values
(in billions of dollars)

appears small, but it may lead to 280

260

large differences in the levels of 240

output over time.

220
200
180

• Consider a 100-year period: 160

140
120
o Country A and B begin at the same 100

level of GDP ($100 billion).

1900 1910 1920 1930 1940 1950 1960 1970 1980 1990 2000

Country A Country B

o Country A grows at 1 percent each year.

o Country B grows at 0.25 percent each
year.

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 Growth Over the Very Long Run
• Sustained increases in standards of living are a recent phenomenon:
• The first agricultural revolution was about 10,000 years ago.
• Yet, only in the last 200–300 years has modern economic growth appeared.
• Economic growth emerges in different places at different times for many
reasons. Some results of this are:
o Standards of living have diverged dramatically.
o Per capita GDP differs remarkably around the world.

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Growth Over the Very Long Run

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 Zooming in on the past 200 years Small differences
can have big effects.
Economic growth doesn’t just mean
you consume more stuff.
 Enables you to live and thrive!
 Fewer people go hungry.
 More sanitary conditions.
 Invest in education and health.
 Longer life expectancy.
But the agricultural and industrial
revolutions didn’t lead to economic
growth everywhere.
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 Growth disasters and miracles
Japan and South Korea
grew quickly in the second
half of the twentieth
Spain was a sixteenth century century!
powerhouse, but between 1600 and
1850 their economy barely grew.
 1950’s real GDP per person was only
2.5× larger than 400 years earlier.
 Rebounded in the second half of
1900s.
Argentina was one of the richest
countries in the world at the start of the
1900s, but then growth stalled.
 Fell behind as other countries grew.
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 Modern Economic Growth
• Looking over the past 150 years: from 1870 to 2018, United States real per capita
GDP rose by more than 15-fold.
• Assuming this rate of growth continues, a typical college student today will earn a
lifetime income about twice that of his or her parents.

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 The Definition of Economic Growth
• Growth of per capita GDP
o The exact rate of change of per capita GDP
• A percentage change
o The change between two periods divided by the value of the variable in the initial period
• Percentage change in GDP between period t and t+1:
•
•

• where g bar (𝑔𝑔)̅ is the associated constant growth rate.

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 Example: Population Growth—1
• Population growth evolves the same way:

• Intuitively, tomorrow’s population in time period t+1 depends on today’s

population in period t.
• If equation (1) is true in time t, it also applies to time t+1. It follows that

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 Population Growth—2
• But, equation (1) gives us the value for
• So, we can plug (1) into (2) to get

• And, we could continue this process for any number of time periods,
• until we recognize the pattern:

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Population over Time

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 The Constant Growth Rule
The constant growth rule states that
(6)

where
• 𝐭𝐭 is the time period,
• 𝐲𝐲𝐭𝐭 is the value of variable 𝑦𝑦 in time 𝑡𝑡,
• 𝒚𝒚𝟎𝟎 is the initial value of variable 𝑦𝑦 in period 0,
• is the constant growth rate.

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 Calculating Growth Rates
 Begin with the constant growth rule:

 Now, solve for .

 Divide both sides by 𝑦𝑦0:

 Raise both sides to the 1/𝑡𝑡 power:

 Subtract 1 from both sides:

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 The Rule of 70
• The Rule of 70:
o If y grows at a rate of g percent per year, then the number of years it takes y to double is
approximately equal to 70/g.
• Notes:
o Small differences in growth rates result in large differences over time.
o The time it takes to double only depends on the growth rate and not on the initial value.

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 Key Definition Diving into the Definition

A production function is like a cookbook:

Why are some countries rich, while other
are poor? What makes some countries  A cookbook describes how different
stagnate while others grow? mixtures of inputs can be combined to
produce a valuable output.
 What determines how much output
each country produces?
Production function: the methods by
which inputs are transformed into
output, which determines the total
production that’s possible with a given set Production functions are behind every good
of ingredients. and service in our society.
 Managers are ”the cookbook” at their
company.
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 Key Definitions Diving into the Definition
The output a country can produce is tied to the A production function describes how
quantity of inputs they use. output varies with inputs.
 The aggregate production function links GDP  Produce more if (1) employ more labor,
(2) workers become more highly skilled,
to labor, human capital, and physical capital.
and (3) accumulate more physical capital.
Labor (L): the sum of all hours worked across
the economy.
Human capital (H): the accumulated knowledge
and skills that make a worker more productive.
Physical capital (K): the tools, machinery, and
structures that are inputs in the production
process.

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 Digging into the Ingredients
A country’s output depends on…
Available inputs: Output is a function of inputs
1. Labor input
2. Human capital Y = f ( L, H, K )
3. Physical capital
And also:
4. Recipes for transforming inputs into output.
 Discovering new and more efficient production techniques allows
us to transform a given quantity of inputs into even more output!

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 Ingredient 1: Labor and Total Hours Worked (1 of 4)

The total quantity of labor input is the sum of all hours worked across the whole economy.

This sum reflects four factors: Population boosts total GDP, but not GDP per person.
1. Population size.  Rapid population growth leads to rapid economic
growth.
2. Working-age fraction of the
population.  More births
3. Share of working-age people  Fewer deaths
who choose to work.  More immigration
4. How many hours each  But this does not necessarily yield higher living
worker puts in. standards.
 Larger GDP gets shared over more people.

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 Ingredient 1: Labor and Total Hours Worked (2 of 4)

The total quantity of labor input is the sum of all hours worked across the whole economy.

This sum reflects four factors: Unfavorable demographics can slow

economic growth.
1. Population size.
 Children and the elderly rarely work.
2. Working-age fraction of the
population.
3. Share of working-age people
who choose to work.
4. How many hours each worker
puts in.

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 Ingredient 1: Labor and Total Hours Worked (3 of 4)

The total quantity of labor input is the sum of all hours worked across the whole economy.

This sum reflects four factors: Women’s increased employment created

economic growth.
1. Population size.
2. Working-age fraction of the
population.
3. Share of working-age people
who choose to work.
4. How many hours each
worker puts in.

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 Ingredient 1: Labor and Total Hours Worked (4 of 4)

The total quantity of labor input is the sum of all hours worked across the whole economy.

This sum reflects four factors: Shorter workweeks reduce GDP but may raise
1. Population size. well-being.
2. Working-age fraction of  The more hours people work, the more GDP
the population. they will produce.
3. Share of working-age  RECALL: Limitation of GDP is that it ignores
people who choose to the benefit of leisure.
work.  Thus, reducing the average work week
4. How many hours each has slowed GDP growth, but probably
worker puts in. improved well-being.

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 Ingredient 2: Human Capital (1 of 3)

A nation’s output also reflects how

productive people are while at work. Primary education develops literacy,
which is a key tool for further learning.
Labor productivity: the quantity of
goods and services that each person
produces per hour of work.

 Tied to a person’s human capital.

 Skills and knowledge a person
develops through education,
training, and practice.

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 Ingredient 2: Human Capital (2 of 3)

Secondary education promotes greater

productivity in a range of jobs.
U.S. economy grew faster than that of other
countries in the twentieth century because
the United States invested more in
education.
 Skeptics’ argument: Education won’t be
useful to blue-collar workers.
 Incorrect!
 In actuality, education boosted
worker productivity!

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 Ingredient 2: Human Capital (3 of 3)

Further gains in human capital will come

from expanding college education.
 Each year of college raises earnings by
around 8%.
 The United States leads the world in the
quantity of education gained.

However, the quality of American

educational outcomes is unexceptional in a
global context.
 Out of 78 countries, the United States
ranks 18th in science, 37th in math, 13th
in reading.

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 Ingredient 3: Capital Accumulation
The right tools and good equipment allow workers to produce more!

Capital stock: the total quantity of physical capital that can be used in the production of
goods and services.

 Physical capital: tools, machines, factories, government provided infrastructure (e.g. roads),
electricity networks, and telecommunications.
Investing in new equipment and structures allows companies to grow their capital stock:
 Investment occurs out of resources that are saved (rather than consumed).
 Foreign investment builds capital stock.
 2018 Toyota and Mazda partnered to build a new car production plant in Huntsville, AL.

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 New recipes for combining ingredients: Technological progress
Technological progress: new methods for Computers embody technological progress:
using existing resources. The computer revolution is another example of
a new recipe.
More output from existing resources:
 Sand is a key ingredient.
 Crop rotation increased crop yield.
 Can both conduct and block electricity.
New and better management techniques:
This new understanding, that sand is a
 Japanese auto industry’s efficient semiconductor, created new recipes in which

Johannes Kornelius/ Shutterstock

management techniques. sand is combined with other ingredients to
New recipes: create chips that power modern computers.
 Oral rehydration therapy blends sugar, We had the ingredients
salt, and water in the right proportions to the whole time!
revive a child dying from cholera-induced
diarrhea.
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 The falling cost of light: Recipes for producing light over the centuries

Light Recipe 1: fire Light recipe 3: electric lightbulb

 Requires 60 hours of gathering  Your great-great-grandparents could
firewood to produce 1,000 lumen- work a 60-hour week to get five
hours of light. months of continuous light.
 Less than what your overhead light gives  Today, with LED lights, 60 hours of
off over the next hour. labor buys you all the light you need
for the rest of your life.
Light Recipe 2: candle
 120 hours of work to either earn the
money or make the candles such that
you could burn one candle for 5 hours
each night for a year.

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 Key take-aways: The ingredients of economic growth

Ingredients of economic growth:

1. Labor input: number of workers to transform raw materials into
products and services that people want to buy.
2. Human capital: the skills and knowledge of people developed
through education, practice, and training.
3. Physical capital: the total amount of tools, machinery, and
structures that can be used in the production of goods and
services.
4. Technological progress: new methods for using existing
resources to produce more valuable output.

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 Analyzing the production function
Insight 1: constant returns to scale means doubling inputs will double output.
 Constant returns to scale: Increasing all inputs by some proportion will cause output
to rise by the same proportion.
 Replication argument: If you want to double the output of your factory, simply
replicate everything you’re already doing to produce twice the output.

+ =
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 Diminishing returns to capital Insight 2: There are diminishing returns
to capital.
GDP per worker Production
 If you only double your physical
function
Small
capital, and don’t change the
increase number of workers, then you will
produce more, but you won’t produce
twice as much.
 More tools are helpful, but at
Large some point, extra tools won’t
increase make much of a difference.
 Law of diminishing returns: When
one output is held constant, increases
in the other inputs will, at some point,
Physical capital begin to yield smaller and smaller
per worker
A A given change in
A increases in output.
physical capital…

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 Catch-up growth
Insight 3: Poor countries can enjoy catch-up growth.

 Catch-up growth: the rapid growth that

occurs when a relatively poor country invests
in its physical capital.
South Korea and the United States from 1970 to
2000:
In 1970, South Korea was relatively poor and had low
levels of physical capital per person.
Both South Korea and the United States increased
physical capital per person by roughly $65,000.
 South Korea saw tremendous growth, while the
U.S. growth wasn’t anywhere near as impressive.
 South Korean GDP grew by a factor of 12!
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 Capital accumulation and the Solow model

The Solow model is used to analyze economic growth.

 Simultaneously analyzes the production function, investment, capital accumulation, and how this all
ties into economic growth.

Insight 4: The capital stock will grow as long as investment outpaces depreciation.

 Depreciation: the decline in capital due to wear and tear, obsolescence, accidental damage, and aging.

RECALL: The production function tells us that more capital per person creates more output per person.

 All together, insight 4 and the production function imply that the economy will keep growing as long
as investment exceeds depreciation.

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 Diminishing returns and depreciation
Insight 5: Physical capital per worker will eventually stop growing.

 Diminishing returns: Each increment of additional capital creates a smaller and smaller addition
to output.
 Rising depreciation: If the fraction of machines that fail each year is fixed, then more machines will
mean more breakdowns  total depreciation grows.
 Conclusion: At some point, capital stock stops growing.

Insight 6: Capital accumulation can’t sustain long-term economic growth.

 When new investment in capital stock merely offsets depreciation, then capital stock reaches a
steady state.
 No growth in capital stock means no growth in output  economic growth stalls unless some
other factor changes, such as technology.
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 Technological Progress A Technological progress moves the
production function upward.
New
GDP per worker production B Produces more output per person
function with any given amount of capital per
worker.

A C Boosts the extra output that each

C
Extra output extra machine produces.
per machine
More output  Investment is now more productive and
from the B Production valuable.
same inputs function
Technological progress is key to
sustained economic growth.

 More output from existing inputs.

Physical capital  Spurs capital accumulation.
per worker

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 Technological progress relies on new ideas

Technological progress is driven by…

 The speed at which new ideas are created.
 How many resources are devoted to generating new ideas.

The absence of technological progress explains why growth took so long to occur.
 Battling to survive meant no spare resources to devote to generating new ideas.
 A few hundred years ago, the opportunity cost of new ideas was less food which meant
starvation.
 Post agricultural and industrial revolution, the opportunity cost of devoting resources to
innovation is lower.
Technological progress allowed us to break the cycle of poverty!

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 The impact of new ideas :
1. Ideas can be freely shared.
 New ideas can be deployed across thousands or millions of people.
2. Ideas do not depreciate with use.
 Don’t need ongoing investments to keep using an idea.
3. Ideas may promote other ideas.
 The discovery of new ideas can be self-sustaining, and can lead to self-
reinforcing economic growth.
 Example: Apple’s invention of the iPhone spurred new ideas for
smartphone applications.
But nonexcludability of ideas creates an incentive to imitate rather than innovate.
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 Concept Check: Diminishing returns

In 2020, Nicaragua’s GDP per person was $1,905.26 USD, while Costa Rica’s GDP
per person was $12,076.81. If both countries increased their physical capital per
person by 10%...
a) what do you think would happen to each country’s GDP per person?
b) do you expect similar changes in each country’s output per person?
a) each country’s GDP per person? b) similar changes?
Both countries will experience an Nicaragua will likely benefit more from the
increase in their output per person, increased capital per person than Costa Rica
because increases in physical capital due to diminishing returns to capital.
increase worker’s productivity.  Costa Rica has a larger capital stock, and
so the additional capital will have less
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impact on their output per person. Macmillan Learning, ©2023
 © Worth Publishers
Key take-aways: The analytics of economic growth

Capital accumulation alone cannot sustain economic growth, but

technology progress can, and technological progress relies on new ideas.

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 Why institutions matter for growth

So far…
 Economic growth is the result of new ideas, investing in human capital, and accumulating
physical capital.
Now we ask…
 What determines whether people are willing to invest in new ideas, human, or physical capital?
 Why invest your time, money, and energy to create something new, if competitors can just copy or
steal or your idea?
 Why work hard if the government can just seize your output or wealth?

Let’s look at people’s incentives and the country’s institutions that shape those incentives.

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 Why institutions matter (1 of 4)

Property rights: control over a tangible or intangible

Institutions that promote
resource.
economic growth:
Having a clear set of laws and a trusted system of
1. Property rights
enforcing those laws means people can spend less time
2. Government stability fighting over particular resources.
3. Efficient regulation
Also, they provide an
4. Government policy incentive for you to
encouraging innovation work hard to get
resources like money,
land, etc.

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Jose Luis Pelaez Inc/DigitalVision/Getty Images
 Why institutions matter (2 of 4)

Corruption and political instability discourages

Institutions that promote
investment and innovation.
economic growth:
Argentina Example:
1. Property rights
Recall Argentina’s stalled economic growth in the
2. Government stability
twentieth century.
3. Efficient regulation
Argentina had…
4. Government policy
 Military coups in 1930, 1943, 1955, 1962, and 1976.
encouraging innovation
 periodic overhauling of its Supreme Court.
 a perception that property rights were insecure.
 a lack of confidence in the central bank to control
inflation.
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 Why institutions matter (3 of 4)

Regulation and rules are essential to a well-functioning

Institutions that promote economy, but they can also be inefficient or excessive.
economic growth:
 Can create more problems than they solve.
1. Property rights
The Good: Regulations can provide basic assurances.
2. Government stability
 Customers know they can trust your product.
3. Efficient regulation
The Bad: Regulations can create excessive
4. Government policy bureaucratic obstacles.
encouraging innovation
 Days it takes to start a new business in…

U.S.A. Argentina Venezuela

6 days 25 days (down from 66 in 2003) 230 days in 2016

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 Why institutions matter (4 of 4)

The government can…

Institutions that promote
economic growth: 1. Create incentives through intellectual property laws.

1. Property rights  Rivals can’t simply copy your work or idea.

2. Government stability  You have exclusive rights to your idea for a period of
time.
3. Efficient regulation
 Allows you to recoup the development costs and
4. Government policy enjoy large profits.
encouraging
innovation 2. Subsidize research and development.
 Government helps lower the cost of innovation, so
businesses do more of it!

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 © Worth Publishers
Key take-aways: Why institutions matter for growth

Institutions provide the framework that creates the right incentives for people
to invest in physical and human capital, and generate new ideas.
1. Property rights: No one can create wealth without property rights!
2. Government stability: Corruption and political instability discourage
investment and innovation by reducing the potential benefits from such
investments.
3. Efficiency of regulation: Excessive red tape can make it hard to invest or
innovate.
4. Government policy can support development of new ideas through…
 Intellectual property rights; subsidizing research and development.

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