Chapter 6 – Economic Growth

What is the Recipe for Economic Growth?

- A fundamental question in economics:
- Why do some countries experience lots of economic growth…while other
countries experience little growth or none at all?

First, Some Semantics

- “Rich” country: One with lots of wealth right onw
- Country with “high economic growth”: One whose wealth is increasing
quickly
- A poor country can have high economic growth.
- A rich country can have low economic growth.

Next, Some Math

- We express the growth rate of a variable as the annual percentage
change of that variable.
- Growth in XX=
Value of XX∈current year−Value of XX ∈ previous year
× 100
Valueof XX ∈ previous year
- Growth rate in real GDP =
Real GDP∈current year −Real GDP∈ previous year
× 100
Real GDP∈ previous year

Per Person or Not? A Reminder

- Real GDP tells us how productive the entire country is.
o Explains why US-China trade agreements are more important than US-
Iceland trade agreements
- Real GDP per person tells us how high the average standard of living is.
o Explains why the average Icelander has higher income than the
average resident of China
- Growth rate for either one is important, but different.

A Little More Math

- Shortcut to calculate growth rate of real GDP per person:
- Growth rate of real GDP per person ≈

Growth rate of real GDP – Growth rate of population

- Only way standard of living can improve: If production increases faster

than population does.

What can Real GDP Growth Mean?

- Analogy:
o A football team wins a lot more games this year than last year.
 2 possible reasons
- If real GDP is higher this year than last year, there are 2 possible reasons.
- Reason 1: Country wasn’t at full employment last year, but now it is.
o Country produced inside the PPF last year.
o Same PPF this year as last year, now producing on the PPF.
- This is not an example of economic growth.
- Just means that last year’s production was inefficient, this year’s is
efficient.
- Reason 2: Production possibilities expanded.
o Country produced at a point on the old PPF last year
o PPF expanded from last year to this year.
o Country is producing on the new PPF this year
- This is an example of economic growth.
- Economic growth = The expansion of production possibilities

More Math Again

- Annual growth rate: Percentage increase in a variable in one year.
- Related question: How long will it take the variable to double?
- Rule of 70: If a variable grows X% each year, it will take about 70/X years
for the variable to double.
- Example: If the price of a bitcoin grows at 10% each year, it will take
about (70/10) = 7 years for the price of a bitcoin to double.
- Applies to any variable you can think of, including real GDP.
Labor: The Gas Pedal of the Economy
- Real GDP depends on the 4 factors of production
- Land: Can’t really change how much of it we have.
- Capital and entrepreneurship: Can change how much we will have
tomorrow. Can’t really change how much we have today.
- Labor: Can change how much we have today.
- More labor today: Like stepping on a gas pedal.
- Potential GDP is achieved when the quantity of labor employed is the full-
employment quantity.

Modeling Labor
- We will use an economic model to determine potential GDP
- Model has two components:
1) Aggregate production function
2) Aggregate labor market

Aggregate Production Function

- X-axis: Quantity of labor (hours per year)
- Y-axis: Real GDP
- “If people in this economy work a total of X hours this uyear, what will eb
the resulting value Y of real GDP?
- More labor hours  More real GDP
- But each additional hour of labor is less productive than the last.
o Why?

Aggregate Labor Market

- Just a graph of the supply and demand for labor.
- X-axis: Quantity of labor (hours per year) in total for the country
- Y-axis: Price of one hour of labor (“real wage rate”)
o Why real wage?
- Workers supply labor.
o Follows Law of Supply!
- Employers demand labor.
o Follows Law of Demand!
- IF today’s real wage rate > equilibrium wage rate,
- … then quantity of labor supplied > quantity of labor demanded.
- Surplus!
- Wage rate will fall toward equilibrium.
- If today’s real wage < equilibrium wage rate,
- …then quantity of labor supplied < quantity of labor demanded.
- Shortage!
- Wage rate will rise toward equilibrium.

Aggregate Labor Market and Aggregate Production

Function Combined
- If today’s real wage rate = equilibrium. Wage rate,
- …then there is neither a shortage nor a surplus.
- We are at full employment.
- When we are at full employment, real GDP = potential GDP
- If we stack the aggregate production function graph on top of the
aggregate labor market graph
- …we see that the equilibrium from the labor market determines the size
of potential GDP.

What Makes Potential GDP Grow?

- We want to know: What is the recipe for economic growth?
- In other words, what forces can increase potential GDP?
- There are two key forces that can make potential GDP gorw:
1) Growth of the supply of labor
2) Growth of labor productivity

1. Growth of the Supply of Labor

- Quantity of labor: Total number of hours worked in the economy
- Quantity of labor changes if any of these change:
1) Average hours per worker
2) Employment-to-population ratio
3) Working-age population
- Most labor supply growth comes from increasing working-age population.
- Population growth increases the supply of labor, but doesn’t change
demand for labor.
- To illustrate an increase in the supply of labor, we go to the aggregate
labor market graph,
- …and shift the labor supply curve…
- …to the right!
- (Aggregate production function does not move.)
- Potential GDP went up in response to an increase in labor supply.
o We moved along the aggregate production function curve to the right.
- What happened to potential GDP per hour of labor?
- It went down.
- Returns to labor are positive by diminishing.

2. Growth of Labor Productivity

- Labor supply growth isn’t the defining characteristic of long-run economic
growth.
- Productivity growth is.
- Labor productivity = Real GDP / Total labor hours
- When labor productivity increases, this means that we can produce more
stuff in the same amount of hours worked.
- What does this look like on our aggregate production function?
- Stretches it upward!
- Increase the labor productivity doesn’t just change the aggregate
production function picture.
- It also changes the aggregate labor market picture
- Doesn’t affect supply of labor.
- But it increases demand for labor.
- If demand for labor increase and supply stays the same, how does this
affect…
- …real wage?
- …number of labor hours?
- So, when labor productivity increase, potential GDP foes up for two
reasons
o Each hour of labor produces more real GDP than it did before
o More hours of labor are employed than before

What Causes Labor Productivity to Grow?

- We now see the results of an increase in labor productivity.
- But what causes that increase in labor productivity.
- Analogy: What are the preconditions for growing a plant?
- If a country wants to have labor productivity growth, first it needs 4
preconditions.
1) Firms
2) Markets
3) Property rights
4) Money
- Once you have the preconditions to grow a plant, what are the variables
that affect its growth rate?
- Once a country has the preconditions to grow labor productivity, the pace
of growth depends on three variables:
1) Physical capital growth (more machines and tools)
2) Human capital growth (more knowledge and expertise)
3) Technological advances (better ideas and new ways of doing things)
- Of the three, technological change has made the greatest contribution to
labor productivity growth.
- Ideas don’t cause growth all by themselves.
- Some technologies are embodied in human capital.
- Example: Geometry
- Has to be learned and shared among people in order to affect labor
productivity.
- But most technologies are embodied in physical capital.
- Example: Computer chip
- Has to be produced and installed in order to affect labor productivity.

Economist’s Ideas about Economic Growth: Theories and

Arguments
- Economists generally agree about what we have learned so far.
- Over the last 250 years, economists have argued about whether growth is
sustainable.
- Can economies keep growing forever?
- Or are there limits on growth?

Classical Growth Theory

- Classical growth theory says that:
- Whenever real GDP per person grows, it’s only temporary. Why?
- Because people are always making babies!
- “Subsistence level”: People have just enough to survive.
- Whenever things get better than subsistence level, more of those babies
survive, so population goes up.
- But then there are more mouths to feed, so we fall back to subsistence
level.
- Classical growth theory is very pessimistic!
- In the long run, we are trapped at subsistence level.
- Key proponent of classical growth theory: Thomas Malthus
- Another name for classical growth theory: “Malthusian theory”
- Some people have similar ideas today: “Modern-day Malthusians”
o Population only has a limited supply of resources
o Earth only has a limited supply of resources
o Climate change is making things worse
o Maybe real GDP per person is going up right now, …but eventually it
will decrease!
- Most economists today do not think this way.

New Evidence, New Theory

- The original Malthusians saw population skyrocketing, so their theory
made sense.
- In the 1900s, birth rates in wealthy countries fell.
- Women had greater choice to work more, have fewer babies.
- Population still going up, just not nearly as fast.
- Improvements in technology result in better standards of living.
- Maybe we aren’t doomed after all?

Neoclassical Growth Theory

- Neoclassical growth theory says that
o Technology important, and
o technology improvements happen at random.
- Some years, we get lucky, and technology improves. Now we get more
stuff per year!
- Then real GGDP per person improves, because populations aren’t growing
so quickly anymore.
- We get to keep that prosperity. It persists.
- But some years we are unlucky, and there is no new technology.
- Then do we to grow this year?
- Probably not.
- We could if we invested in a lot of new capital.
- But returns to physical capital are diminishing.
o Eventually it’s not worth it to invest in more physical capital
- Conclusion: In the long run, the economy can only grow if technology
improves.

New Growth Theory

- Knowledge is a public good: Everybody gets to enjoy it!
- Knowledge capital is not subject to diminishing returns.
- As long as people want better lives, people will create new technologies.
- We can have permanent growth.
- A Malthusian looks at a person and sees a mouth to feed.
o Population growth limits economic growth
- Each theory illustrates a reality about the world.
- New growth theory does the best job of fitting facts of today’s world.