1 Chapter 6 ECONOMIC GROWTH Define and calculate the growth rate and explain the implications of sustained growth in economic activity Briefly describe the economic growth trends in the United States and other countries Explain what makes potential GDP grow Explain the sources of labor productivity growth In this chapter- 3 World Economic Growth
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Chapter 6
ECONOMIC GROWTH
Define and calculate the growth rate and explain
the implications of sustained growth in economic
activity
Briefly describe the economic growth trends in the
United States and other countries
Explain what makes potential GDP grow
Explain the sources of labor productivity growth
In this chapter-
3
World Economic Growth
2
Why is Economic Growth Important?
• Measured as growth in real GDP per person (per
capita) - real income per capita.
– Real GDP per capita = 𝑅𝑒𝑎𝑙 𝐺𝐷𝑃
𝑃𝑜𝑝𝑢𝑙𝑎𝑡𝑖𝑜𝑛
• Growth means rising living standard, a higher
quality of life
• Clearly, not a perfect measure.
– want to consider items such as education, environment,
good health, leisure time
– distribution of income
4
High Quality of Life in Wealthy Countries Goes Beyond GDP
5
Growth Rate
• Growth rate is a percent change:
𝑅𝑒𝑎𝑙 𝐺𝐷𝑃 𝑐𝑢𝑟𝑟𝑒𝑛𝑡 𝑦𝑒𝑎𝑟 − 𝑟𝑒𝑎𝑙 𝐺𝐷𝑃 𝑝𝑟𝑒𝑣𝑖𝑜𝑢𝑠 𝑦𝑒𝑎𝑟
𝑅𝑒𝑎𝑙 𝐺𝐷𝑃 𝑝𝑟𝑒𝑣𝑖𝑜𝑢𝑠 𝑦𝑒𝑎𝑟 𝑥100
For 2016: 51,549 −51,110
51,110 𝑥100 = 0.85%
• Small differences in GDP growth rate matter a lot
over time
• The rule of 70 – if a variable is growing by X percent per year it will double in
approximately 70 / X years
– 70/2 = 35 years - 2% growth per year doubles in 35 years
– 70/4 = 17.5 years - 4% growth per year doubles in 17.5years 6
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Importance of Economic Growth
• US real GDP per capita is currently $52,000
• Is been growing at 1.2% annual growth since
2009. At this rate, per capita real GDP will grow
to $52,000(1.012)20 = $66,010 in 20 years
• At 2% annual growth, this will grow to
$52,000(1.02)20 =$77,270 in 20 years
• Growth rate matters!
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Growth Applies to Investment Returns?
Suppose you have $50,000 to invest
• At 2% annual growth in a savings account this
will grow to $50,000(1.02)20 =$74,300 in 20
years
• and $90,300 at 4%.
• At 7%, in the stock market, $50,000(1.07)20
=$193,480 in 20 years
• Growth rate matters!
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The Basics of Economic Growth
Economic Growth Versus Business Cycle Expansion
• Real GDP can increase for two distinct reasons:
1. The economy might be returning to full employment in an
expansion phase of the business cycle.
2. Potential GDP might be increasing.
• The expansion of potential GDP is economic
growth.
• The return to full employment in an expansion
phase of the business cycle isn’t economic growth.
4
The Business Cycle
peak
trough
+3%
+4%
-2%
Long-run economic growth is in this example is 3%.
In the expansion phase of the cycle, the growth rate is > the trend.
Long-Term Growth Trends
From 1914 to 2014, growth in real GDP per person
in the United States averaged 2 percent a year.
• Real GDP per person fell a lot during the Great
Depression and rose rapidly during World War II.
• Growth was rapid during the 1960s.
• Growth slowed during the 1970s and sped up
again in the 1980s and1990s.
Figure on the next slide illustrates this.
Long-Term Growth Trends
5
Real GDP Growth in the
World Economy
Figure shows the growth
in the rich countries.
Japan grew rapidly in the
1960s, slower in the
1980s, and stagnated
during the 1990s.
Growth in Europe Big 4,
Canada, and the United
States has been similar.
Long-Term Growth Trends
Figure shows the growth
of real GDP per person in
a group of poor countries.
The gaps between real
GDP per person in the
United States and in these
countries have widened.
Economic Growth Trends
Potential GDP
What Factors Determine Potential GDP?
• Potential GDP is the quantity of real GDP
produced when the quantity of labor employed
is the full-employment quantity.
• To determine potential GDP we use a model
with two components:
• An aggregate production function
• An aggregate labor market
• Potential GDP is supply driven.
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Aggregate Production
Function
The aggregate
production function tells
us how real GDP changes
as the quantity of labor
changes when all other
influences on production
remain the same.
An increase in the quantity
of labor increases real
GDP. Labor is measured
as billions of hours worked
per year.
What Determines Potential GDP
What Determines Potential GDP
The Labor Market
• The demand for labor shows the quantity of labor
demanded and the real wage rate.
• The real wage rate is the money wage rate divided by
the price level. It’s the purchasing power of the money
wage.
• The supply of labor shows the quantity of labor
supplied and the real wage rate.
• The labor market is in equilibrium at the real wage rate
at which the quantity of labor demanded equals the
quantity of labor supplied.
Figure illustrates labor
market equilibrium.
Labor market equilibrium
occurs at a real wage rate of
$35 an hour and 200 billion
hours employed.
At a real wage rate above
$35 an hour, there is a
surplus of labor and the real
wage rate falls.
What Determines Potential GDP
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At a real wage rate
below $35 an hour,
there is a shortage of
labor and the real
wage rate rises.
At the labor market
equilibrium, the
economy is at full
employment.
What Determines Potential GDP
Potential GDP
The quantity of real GDP
produced when the
economy is at full
employment is potential
GDP.
In this example, the
economy is at full-
employment with 200
billion hours of labor
employed and potential
GDP is $13 trillion.
What Determines
Potential GDP
How Potential GDP Grows
Two forces drive growth in potential
real GDP:
Growth in the supply of labor
Growth in labor productivity
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How Potential GDP Grows
Growth in the Supply of Labor (total hours
worked)
The total number of hours worked by all the
people employed change as a result of changes
in:
1. Average hours per worker
2. Employment-to-population ratio
3. Population growth
(1) (2) (3)
𝑻𝒐𝒕𝒂𝒍 𝑯𝒐𝒖𝒓𝒔 =𝑻𝒐𝒕𝒂𝒍 𝑯𝒐𝒖𝒓𝒔
𝑻𝒐𝒕𝒂𝒍 𝑬𝒎𝒑𝒍𝒐𝒚𝒎𝒆𝒏𝒕𝒙
𝑻𝒐𝒕𝒂𝒍 𝑬𝒎𝒑𝒍𝒐𝒚𝒎𝒆𝒏𝒕
𝑷𝒐𝒑𝒖𝒍𝒂𝒕𝒊𝒐𝒏𝒙 𝑷𝒐𝒑𝒖𝒍𝒂𝒕𝒊𝒐𝒏
How Potential GDP Grows
The Effects of Population Growth
• An increase in population increases the supply of
labor.
• With no change in the demand for labor, the
equilibrium real wage rate falls and the
aggregate hours increase.
• The increase in the aggregate hours increases
potential GDP.
The labor supply curve
shifts rightward.
The real wage rate falls.
Aggregate hours
increase.
Effect of Population Growth
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Now we go to the
production function.
The increase in aggregate
hours increases potential
GDP.
Because of the diminishing
returns, the increased
population …
increases real GDP, …
but decreases real GDP per
hour of labor - (16/300 < 13/200)
Effect of Population Growth
How Potential GDP Grows
Growth of Labor Productivity
Population growth increases aggregate hours and
real GDP, but to increase real GDP per person,
labor must become more productive.
Labor productivity is the quantity of real GDP produced
by an hour of labor (16/300 in our example)
If labor becomes more productive, firms are willing to pay
more for a given number of hours so the demand for labor
increases.
Figure shows the effect of
an increase in labor
productivity.
The increase in labor
productivity shifts the
production function
upward.
How Potential GDP Grows
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In the labor market:
An increase in labor
productivity increases the
demand for labor.
With no change in the
supply of labor, the real
wage rate rises …
and aggregate hours
increase.
Growth in Labor Productivity
And with the increase in
aggregate hours, potential
GDP increases.
How Potential GDP Grows
Why Labor Productivity Grows
The growth of labor productivity depends on:
Growth in Physical Capital
Growth in Human Capital
Technological advances
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Why Labor Productivity Grows
Physical Capital Growth
Investment in new capital (more plant and equipment)
increases capital per worker and increases labor
productivity.
Human Capital Growth
Human capital acquired through education, on-the-job
training, and learning-by-doing is the most fundamental
source of labor productivity growth.
Technological Advances
Technological change - the discovery and the application
of new technologies and new goods – is a major driver