Copyright © 2008 Pearson Addison-Wesley. All rights reserved. Chapter 26 Long-Run Economic Growth.

Copyright © 2008 Pearson Addison-Wesley. All rights reserved.

Chapter 26

Long-Run Economic Growth

26-2Copyright © 2008 Pearson Addison-Wesley. All rights reserved.

In this chapter you will learn to

3. Explain the main elements of Neoclassical growth theory.

2. Describe the four fundamental determinants of growth in real GDP.

1. Describe the costs and benefits of economic growth.

4. Describe new growth theories based on endogenous technical change and increasing returns.

5. Explain why resource exhaustion and environmental degradation create challenges for public policy directed at sustaining economic growth.


Sustained increases in Y* are a more powerful method of raising material living standards than the removal of recessionary gaps.

Even small differences in annual growth rates can result in significant changes in living standards after many years.

Consider GDP, per capita GDP, and GDP per worker.

The Nature of Economic Growth


Figure 26.1 Three Aspects of Economic Growth


Table 26.1 The Cumulative Effect of Economic Growth


Benefits of Economic Growth

2. Alleviation of Poverty

- many do not share directly in the growth

- but redistribution is easier in a growing economy

1. Rising average Material living standards

APPLYING ECONOMIC CONCEPTS 26.1

An Open Letter from a Supporter of the “Growth Is Good” School


Costs of Economic Growth

1. Sacrifice of Current Consumption

- growth is often encouraged by increasing investment and saving

- this requires less consumption (opportunity cost of economic growth)


Figure 26.2 The Opportunity Cost of Economic Growth


APPLYING ECONOMIC CONCEPTS 26.2

An Open Letter from a Supporter of the “Growth Is Bad” School

2. Social Costs of Growth

- growth usually involves the displacement of some firms and workers

- this process involves real transition costs

The Opportunity Cost of Growth


Sources of Economic Growth

1. Growth in the labour force

2. Growth in human capital

The four fundamental sources of economic growth are:

3. Growth in physical capital

4. Technological improvement

Different theories emphasize different sources of growth.


Established Theories of Economic Growth

Focus on the Long Run

We focus on the long run when real GDP is equal to potential output, Y*.

We hold Y* constant and let the interest rate be determined endogenously by desired saving and desired investment.


Investment, Saving, and Growth

Our model has two parts:

Investment — increases in the stock of capital — lead to increases in the future level of Y*.

Saving by households (and firms) is used to finance this investment.

- interest rate is the “price” that equilibrates this market


Firms’ investment demand is negatively related to the real interest rate.

National saving = private saving + public saving

NS = Y* - T - C + (T - G)

= Y* - C - G

If C is negatively related to the interest rate, then NS is positively related to the interest rate.

Investment, Saving, and Growth


Figure 26.3 The Long-Run Connection between Saving and Investment


Figure 26.4 Increases in Investment Demand and the Supply of National Saving


Empirically, countries with high investment rates also have high growth rates.

Figure 26.5 Cross-Country Investment and Growth Rates


Neoclassical Growth Theory

This theory begins with the idea of an aggregate production function:

GDP = FT(L,K,H)

- L is the total amount of labour

- K is the stock of physical capital

- H is the quality of human capital

- T is the state of technology

FT reflects the assumption that changes in technology will change the production function.


Key assumptions about the aggregate production function are:

1. Diminishing marginal product of both K and L

- when either factor is changed in isolation

2. Constant returns to scale

- when both K and L are changed in equal proportions

Properties of the Aggregate Production Function


Figure 26.6 The Aggregate Production Function and Diminishing Marginal Returns


Holding K constant, increases in L generate positive but diminishing increments to output.

Figure 26.6 The Aggregate Production Function and Diminishing Marginal Returns


1. According to the law of diminishing returns, the MP of L eventually falls as each successive unit of L is used (for a fixed amount of other factors).

increases in population lead to increases in GDP but eventually to reductions in per capita GDP

falling material living standards

Key Predictions of the Neoclassical Model


3. The assumption of constant returns to scale means that if K and L grow at the same rate there will be no improvements in material living standards.

GDP will grow but per capita GDP will be constant.

2. Diminishing MP of K also means that capital accumulation on its own brings smaller and smaller increases in real per capita GDP.

Key Predictions of the Neoclassical Model


In the Neoclassical growth model, technological change is necessary for sustained growth in living standards.

Much technological change is embodied in new capital equipment.

investment is crucial

LESSONS FROM HISTORY 26.1

Should Workers Be Afraid of Technological Change?

The Importance of Technological Change


Measuring technological change is difficult.

Robert Solow (MIT)- his “growth accounting” method estimates technical change as the part of growth that is unexplained by capital accumulation or labor-force growth

the “Solow residual”

Can We Measure Technological Change?


Endogenous Technological Change

New growth theory emphasizes the process of innovation and the incorporation of new technology:

• learning-by-doing

• knowledge transfer

• market structure and innovation

• shocks and innovation

New Growth Theories


Increasing Marginal Returns

New growth theories also emphasize the possibility that each new increment of investment is more productive than the last.

- contrasts with the Neoclassical assumption of diminishing marginal returns.

The sources of increasing returns usually fall into one of two categories:

• market-development costs

• increasing returns to knowledge


Are there Limits to Growth?

Resource Exhaustion

Current technology and resources could not support the entire world’s population at the average U.S. living standard.

- but absolute limits to growth may not be relevant

- technology is constantly improving, suggesting that living standards can continually improve

- but technological improvements are not automatic — they do not “just happen”


Pollution

Conscious management of pollution was unnecessary when the world’s population was one billion people, but such management has now become a pressing matter.

Conclusion

Growth can help the world address many problems. But further growth must be sustainable growth, which should be based on knowledge-driven technological change.

Are there Limits to Growth?

Copyright © 2008 Pearson Addison-Wesley. All rights reserved. Chapter 26 Long-Run Economic Growth.

Documents