Macroeconomics Principles

Applications and Tools 8th Edition

OSullivan Solutions Manual
Visit to download the full and correct content document: https://testbankdeal.com/dow
nload/macroeconomics-principles-applications-and-tools-8th-edition-osullivan-solution
s-manual/
 8
Why Do Economies Grow?
Chapter Summary
In this chapter, we explore the mechanisms of economic growth. Although economists do not have a
complete understanding of what leads to growth, they regard increases in capital per worker,
technological progress, human capital, and governmental institutions as key factors. In this chapter, we
discuss these factors in detail. Here are the main points of the chapter:
• Per capita GDP varies greatly throughout the world. Whether poorer countries in the world are
converging with richer countries is subject to lively debate.
• Economies grow through two basic mechanisms: capital deepening and technological progress.
Capital deepening is an increase in capital per worker. Technological progress is an increase in
output with no additional increases in inputs.
• Ongoing technological progress will lead to sustained economic growth.
• A variety of theories attempt to explain the origins of technological progress and determine how we
can promote it. These theories include spending on research and development, creative destruction,
the scale of the market, induced inventions, and education and the accumulation of knowledge.
• Governments can play a key role in designing institutions that promote economic growth.
• Investments in human capital are a key component of economic growth.

Learning Objectives:
1. Calculate economic growth rates.
2. Explain the role of capital in economic growth.
3. Apply growth accounting to measure technological progress.
4. Discuss the sources of technological progress.
5. Assess the role of government in assisting economic growth.

Approaching the Material

Continuing the theme of making economics personal, focus as much as you can on human capital and its
effects on the economy. Students will be able to relate to how investing in themselves—education,
training, new skill sets—will increase their ability to be more productive and earn more money. If the
students understand this, you can then relate how economies are made up of individuals who become
more productive. You can now add in capital goods and technological changes to explain growth.

Chapter Outline
Capital deepening = increases in the stock of capital per worker.

Technological Progress = more efficient ways of organizing economic affairs that allow an economy to
increase output without increasing inputs.

Human Capital = the knowledge and skills acquired by a worker through education and experience and
used to produce goods and services.

8.1 Economic Growth Rates

A. Review
1. GDP measures the total value of final goods and services produced in a country. But it does
not adjust for size of a country.
2. Real GDP per capita is the gross domestic product per person adjusted for changes in
constant prices. It is the usual measure of living standards across time and between countries.
B. Measuring Economic Growth
1. Growth rates measure percentage rate of change of a variable from one period to another
using the following formula:

growth rate =
(GDP in year 2 − GDP in year 1)
(GDP in year 1)
2. The rule of 70 is a rule of thumb that says output will double in 70/x years, where x is the
percentage rate of growth.

 Teaching Tip
This is a good point to look at some examples of what this implies. Suppose your income
went up by 3 percent a year. This implies your income will double in 23.33 years. But
increasing that to 5 percent drops the doubling time to 14 years.

C. Comparing the Growth Rates of Various Countries

1. Comparing GDP across countries is difficult.
a. Different currencies
b. Different consumption patterns
2. Some economists have accounted for variations in the cost of living in different countries by:
a. Collecting vast amounts of data on prices of comparable goods
i. Same good
ii. Same quality
b. Using the prices of all these goods to adjust all prices in other countries to equivalent
U.S. prices
 D. Are the Poor Catching Up?
1. The very poor countries have extremely low figures.

 Teaching Tip
GDP in poor countries may be underestimated because most poor farmers consume their
production instead of selling it, and therefore, it is not included in GDP.

2. Growth rates vary quite dramatically across countries:

3. Convergence is the process by which poorer countries close the gap with richer countries in
terms of real GDP per capita. Is there convergence, i.e., do poorer countries close the gap by
growing faster?
a. Evidence in favor of convergence is clear in developed economies.
b. For less-developed countries, the picture is less clear.
c. All in all, economists find only weak evidence in favor of convergence.

Review this key question and the related application:

Question 1: How may global warming affect economic growth?

APPLICATION 1: GLOBAL WARMING, RICH COUNTRIES, AND POOR COUNTRIES

This Application explains how though many people believe that global warming will hurt economic
development, research shows that the effects are more complex. Recent research by economists
Melissa Dell, Benjamin Jones, and Benjamin Olken provides some useful insights. These include: If
global warming can be deferred sufficiently far into the future, poorer countries will have opportunities to
develop and perhaps be less subject to global warming trends. However, if global warming occurs
relatively soon, then poor countries are likely to be adversely affected.

Review this key question and the related application:

Question 2: Is there a necessary trade-off between equality and growth?

APPLICATION 2: ECONOMIC EQUALITY MAY SUSTAIN ECONOMIC GROWTH

Recent research suggests that more equality may be beneficial to economic growth. An explanation may
be that governments are better able to make difficult choices to sustain growth when there is more
equality. Other factors include the quality of political institutions and the economy’s openness to trade.

8.2 Capital Deepening

One of the most important mechanisms for economic growth is an increase in capital per worker.
A. Recall from last chapter, that an increase in capital increases output even if labor does not change.
1. Additional capital shifts the production function up, increasing output.
2. Additional capital shifts labor demand out, increasing real wages.
3. An economy produces more per worker with more capital.
  Teaching Tip
One easily understandable example is four people digging a hole. First, dig with their
hands (no capital). Next, add a shovel and see what happens to output per worker. Now
add another shovel and so on. This shows explicitly how output per worker rises as you
increase capital per worker.

B. Saving and Investment

The simple model of capital deepening looks at the relationship between saving (income that is
not consumed) and investment.
1. Simple example of capital deepening
a. Consider an economy with constant population, full employment, no government, and no
foreign sector.
b. Output is purchased for consumption or investment, and income is either consumed or
saved.
i. C + I = C + S
ii. S = I
c. The stock of capital depends on two factors: gross investment and depreciation.
▪ Kt+1 = Kt + It
▪ Depreciated Capital = Kt + Net investment
d. Higher savings, i.e., higher investment, increases the capital stock, i.e., creates capital
deepening.
C. How Do Population Growth, Government, and Trade Affect Capital Deepening?
1. Population growth: A larger labor force increases total output. But with a fixed capital stock,
output goes up at a decreasing rate as it lowers output per worker.
2. India has the world’s second largest population. But due to diminishing returns, output per
capita in India is very low.

Remind students of the following key principle:

KEY PRINCIPLE: PRINCIPLE OF DIMINISHING RETURNS

Suppose that output is produced with two or more inputs and that we increase one input while holding the
other inputs fixed. Beyond some point—called the point of diminishing returns—output will increase at a
decreasing rate.

 Teaching Tip
Discuss the relationship between population and economic growth here—simply producing
enough to feed a large population leaves little room for producing capital goods.

3. Government spending and taxation: suppose the government increases taxes to spend more
on noninvestment goods and services.
a. Higher taxes → lower income → lower private savings → lower investment → less
capital deepening
b. If the government spent the revenue on investment goods and services → more capital
deepening
 4. Foreign sector: A trade deficit made up of capital goods increases capital deepening.
5. Capital deepening has limits because of the principle of diminishing returns.
a. With a fixed labor force, an increase in capital increases output at a decreasing rate.
b. Since savings is related to output, savings increases at a decreasing rate.
c. However, if capital depreciates, an increase in the capital stock increases depreciation.
See the appendix to this chapter for discussion of Solow growth model and the
relationship between gross investment and depreciation.
d. There is a natural point where gross investment is equal to depreciation. K cannot
increase above this point; higher savings rates increase investment, but higher capital
increases depreciation more.

8.3 The Key Role of Technological Progress

A. Technological progress is when an economy operates more efficiently by producing more output
without using more inputs.
1. Invention of the light bulb, thermometer, disposable diapers, etc.
2. New ideas making us more effective

 Teaching Tip
A good example of a new idea is electricity. Not just the invention of electricity, but how
it allowed factories to be reconfigured due to having the ability to move power around a
factory easily.

B. How do we measure technological progress?

1. Recall the production function: Y = F(K, L)
2. Robert Solow, a Nobel laureate from M.I.T., added a measure of technological progress, A:
a. Y = F(K, L, A)
3. Growth accounting is a method to determine the contribution to economic growth from
increased capital, labor, and technological progress.
a. We observe Y, K, and L over time in most economies.
b. How much of the change in Y is due to changes in K and changes in L? Whatever growth
is left over must be due to A. This is called growth accounting.
C. Using Growth Accounting
1. Growth accounting can be used to understand different aspects of economic growth.
2. Look at the following applications for examples.
3. Labor productivity is the output produced per hour of work.

Review this key question and the related application:

Question 3: How can we use economic analysis to understand the source of

growth in different countries?
APPLICATION 3: SOURCES OF GROWTH IN CHINA AND INDIA

China grew at a rate of 9.3 percent while India grew at a rate of 5.4 percent. Employment grew at
2 percent per year in both countries so the difference must be attributed to capital deepening and
technological progress. In particular China’s more rapid growth can be attributed to a more rapid
accumulation of physical capital and more rapid technological progress.
Review this key question and the related application:

Question 4: How do you measure the technological revolution?

APPLICATION 4: GROWTH ACCOUNTING AND INTANGIBLE CAPITAL

Economists have created a measure of “intangible” capital based on expenditures on research and
development, marketing, design, and customer support. Intangible capital is an important source of
economic growth. It has exceeded the contribution from traditional or tangible capital in recent years.

8.4 What Causes Technological Progress?

A. Research and development funding
B. Monopolies that spur innovation: Creative destruction is the view that a firm will try to come up
with new products and more efficient ways to produce products to earn monopoly profits.
1. Without the ability to reap the rewards of innovation, a company will not fund research and
development.
2. The government grants patents to allow for temporary monopolies for 20 years.
C. The scale of the market: If markets are too small, there are not enough incentives to engage in
technological progress.
D. Induced innovations: Many innovations are the result of a need to cut cost.
E. Education, Human Capital, and the accumulation of knowledge: Increasing the investment in
human capital increases the productivity of the labor force.
F. New growth theory: modern theories of growth that try to explain the origins of technological
progress.

Review this key question and the related application:

Question 5: How do varying political institutions affect economic growth?

APPLICATION 5: THE ROLE OF POLITICAL FACTORS IN ECONOMIC GROWTH

This Application discusses how economist Daron Acemoglu of the Massachusetts Institute of Technology
has written extensively about the role of political institutions and economic growth. Acemoglu
distinguishes broadly between two types of political institutions: authoritarian institutions, such as
monarchies, dictatorships, or tightly controlled oligarchies, and participatory institutions, such as
constitutionally limited monarchies and democracies. History has witnessed growth under both types of
regimes. This research shows that transformative economic growth requires participatory institutions.

 Teaching Tip
Now might be a good time to revisit production possibility curves, pointing out that poor
countries have to devote most of their production capacity to food production, which
leaves few resources for anything else. Therefore, they are not producing much capital,
and the production possibilities curve does not move out over time.
Review this key question and the related application:

Question 6: Did culture or evolution spark the Industrial Revolution?

APPLICATION 6: CULTURE, EVOLUTION, AND ECONOMIC GROWTH

In studying the economic history of England before the industrial revolution, Professor Gregory Clark
found that the children of the more affluent were more likely to survive. Over time, they became a larger
and larger portion of the population, bringing their social virtues such as thrift and hard work with them.
This created a society more likely to embrace changes in science and technology, making the Industrial
Revolution more likely.

8.5 A Key Governmental Role: Providing the Correct Incentives and Property
Rights
A. Governments play a critical role in a market economy by ensuring that contracts are upheld and
that property rights are enforced.
B. This allows businesses and individuals to enter into economic transactions.
C. Without this, people are reluctant to trade and the incentive to innovate is muted.

 Teaching Tip
World War II is a classic example of how war destroys the capital stock of a country and
reduces its productive capacity. Explain to the students how much of the capital stock of
Germany and Japan was destroyed during the war. With the help of the United States,
huge investments of new capital took place in both countries leading to tremendous rates
of economic growth in both countries. A discussion point with the students would be
what is going to happen in post-war Iraq.

Review this key question and the related application:

Question 7: Why are clear property rights important for economic growth in
developing countries?
APPLICATION 7: LACK OF PROPERTY RIGHTS HINDERS GROWTH IN PERU

The Application points out that in many South American cities, the poor live in slums without any clear
title to the real estate they occupy. A Peruvian economist, Hernando DeSoto, points out that without clear
property rights, people are not willing to make long-term investments. Perhaps more importantly, they are
unable to use property to borrow money.
Additional Applications to Use in Class
Question: How is direct impact different than total impact?

ADDITIONAL APPLICATION: DEM CONVENTION BOOSTS DENVER MERCHANTS

Briggs, Bill
“Dem Convention Boosts Denver Merchants”
Posted 8/28/2008 on MSNBC.com
MSNBC

Summary: Key Points in the Article

Denver business owners are smiling all the way to the bank after the Democratic National Convention
(DNC). While several economists predict large gains from conventions others point out the local
customers are often “crowded out” and negate the convention sales. Previous political convention cities
back up the crowding-out theory. Boston, host of the 2004 DNC, posted a $150 million direct impact
from the convention. However, subsequent studies indicated the impact was closer to $15 million after
factoring in spending declines from locals and regular tourism.

However Denver points out that Boston’s mayor asked locals to stay home to relieve congestion whereas
Denver’s mayor asked locals to come into town and participate. A full house in every restaurant and bar
coupled with record sales appears to vindicate Denver’s strategy. Critics still maintain that time will tell
and when the numbers shake out the convention’s impact will not be the $160 million that Denver’s
promoters promised. Proponents maintain they may be right…it may be even higher.

Analyzing the News

More customers mean more unit sales and higher prices. Some businesses such as local hotels actually
took the forecasts to heart and more than doubled their room rates. With occupancy at 100 percent, it is
easy to see that their revenues and profits increased at least for that week.

Thinking Critically Questions

1. How can hotels increase their room rates and increase profits?
2. What is “crowding out” in this sense?
3. How is direct impact different than total impact?

Question: How can privatizing help some countries?

ADDITIONAL APPLICATION: NATIONAL TREASURE

Victor, David G
“National Treasure”
Posted 4/17/2008 on Newsweek

Summary: Key Points in the Article

This article uses Mexico’s state run oil company, Pemex, as a case study into why we should fear
continued high prices for oil. Pemex has been, and continues to be, a cash cow for the Mexican
government. However, the government’s short-sighted approach has been to limit exploration and overall
investment in Pemex and use the profits for other government interests. The company currently accounts
for about 40 percent of Mexican government income.
Now Pemex’s aging technology and existing oil fields are in decline and are impossible to fix given the
political handcuffs the company faces. Managers are hampered by laws that won’t allow external
investors and political parties that have their own short-term interests in mind.

Mexico’s plight seems ridiculous to most capitalists who understand risk taking and the potential rewards
in the oil business, but the country’s approach is not isolated. Brazil, Kuwait, Venezuela, and other oil-
rich countries seem bent on making decisions that hamper the global supply of oil. With two-thirds of the
planet’s oil controlled by various governments, it doesn’t appear that supply issues will be resolved any
time soon as demand for oil continues to escalate.

Analyzing the News

Note that oil prices, like any other commodity, will continue to rise as long as demand increases are not
met with increases in supply. And, if the author David Victor is right, supply may decrease as fields and
technologies continue to age without additional investment.

Thinking Critically Questions

1. Why are the governments allowing the oil fields to decline?
2. Why do the people in these countries allow these short-sighted approaches to continue?
3. How would privatizing help these countries?
Appendix to Chapter 8: A Model of Capital Deepening
The chapter alludes to the relationships between saving, depreciation, and capital deepening. The
appendix presents a simple model of capital deepening that shows explicitly the links between saving,
depreciation, and capital deepening. The model helps us to understand more fully the critical role that
technological progress must play in economic growth. The main points of the appendix are:
• Capital deepening, leading to economic growth and increased real wages, will occur as long as
total saving exceeds depreciation.
• Eventually the process of capital deepening will come to a halt as depreciation catches up with
total saving.
• A higher saving rate will promote capital deepening, but eventually the economic growth comes
to an end as the economy reaches the new equilibrium.
• Technological progress not only directly raises output, but it also allows capital deepening to
occur.

8.1A A Model of Capital Deepening

A. Simple model of capital deepening to focus on the relationships between savings, depreciation,
and capital deepening developed by Robert Solow.
B. Look at Figure 8A.1 showing the production function. Recall that it exhibits the principle of
diminishing returns.

Remind students of the following key principle:

KEY PRINCIPLE: PRINCIPLE OF DIMINISHING RETURNS

Suppose that output is produced with two or more inputs and that we increase one input while holding the
other inputs fixed. Beyond some point—called the point of diminishing returns—output will increase at a
decreasing rate.

C. Assumptions of the Growth Model

1. Savings is a constant proportion of income and without government or a foreign sector,
savings equals investment. Thus, investment is a constant proportion of income.
2. Capital depreciates at a constant rate.
D. Finally, look at changes in the stock of capital:
1. Savings (= sY) increases capital
2. Depreciation (= dK) decreases capital
3. So, the change in the stock of capital = sY – dK
E. Now look at Figure 8A.3 which shows all of the relevant relationships together.
1. At K0, dK < sY, which means that the capital stock is growing.
2. This is also true at K1.
3. So, K continues growing until K = K*.
4. If K > K*, dK > sY and the capital stock decreases until K = K*.
5. K* is the long-run equilibrium capital stock.
F. Figure 8A.4 shows what happens if the savings rate rises.
1. Higher s leads to an increase in K and thus an increase in Y.
G. What happens with technological progress?
1. Better technology leads to an increase in K and thus an increase in Y.
 H. Summary of Basic Points of Solow Model (directly from the appendix)
1. Capital deepening, an increase in the stock of capital per worker, will occur as long as total
saving exceeds depreciation. As capital deepening occurs, there will be economic growth and
increased real wages.
2. Eventually, the process of capital deepening will come to a halt as depreciation catches up
with total saving.
3. A higher saving rate will promote capital deepening. If a country saves more, it will have a
higher output. But eventually, the process of economic growth through capital deepening
alone comes to an end, even though this may take decades to occur.
4. Technological progress not only directly raises output, but also it allows capital deepening to
continue.

Solutions to End-of-Chapter Exercises

Chapter 8
SECTION 8.1: ECONOMIC GROWTH RATES
1.1 per capita real GDP
1.2 lower
1.3 False
1.4 35
1.5 This is a Web exercise.
1.6 The country with lower GDP but faster growth will overtake the larger, slower-growing country
within 35 years.
1.7 It would say there was no convergence or divergence.
1.8 6 percent
1.9 Yes, poor countries that have large agricultural exports are particularly vulnerable to increases in
temperatures. But in 20 years, India is likely to be more developed and relatively less vulnerable to
temperature increases.
1.10 Perhaps sustained growth would lead to lower unemployment and higher incomes for the poor and
middle class. This might reduce inequality. Note that this story is the opposite of the one discussed
in Application 2, where equality caused growth.
1.11 The data does support the theory of convergence.

SECTION 8.2: CAPITAL DEEPENING

2.1 d.
2.2 increase, decrease
2.3 180
2.4 False (it would be true for a trade deficit).
2.5 c.
2.6 It is false, because an increase in the supply of capital will increase the demand for labor and raise
real wages. It would, however, reduce the return to capital.
2.7 Total investment increases.
2.8 No, the increase in the trade deficit just increased consumption. Increasing consumption does not lead to
more capital deepening.

SECTION 8.3: THE KEY ROLE OF TECHNOLOGICAL PROGRESS

3.1 technological progress
3.2 technological progress
3.3 True
3.4 False
3.5 In both of these examples, capital (in the form of computers) are employed. Some of the benefits to
consumers would be attributed to the increase in capital.
3.6 This is consistent with the growth accounting finding that technological change has occurred more
rapidly in China than in India.
3.7 These are examples of intangible capital. They are similar to research and development
expenditures and are a form of capital.
3.8 Their finding reflects the observation that computer technology and information technology have
become more important in recent years. Much expenditure in this area is intangible capital.
3.9 Employers have increasingly compensated employees in ways for which the employers have a
comparative advantage (e.g., provision of group health insurance rather than wages). Hence, health
insurance is not provided “free” to employees.

SECTION 8.4: WHAT CAUSES TECHNOLOGICAL PROGRESS?

4.1 c. Adam Smith
4.2 False
4.3 d.
4.4 decrease
4.5 Shorter patent terms will reduce investment in research and development activities, eventually
reducing the supply of new drug products.
4.6 While the quote does make an interesting point, dictators might fear the disruption that would occur
with too rapid economic growth as it would give economic power to potential adversaries.
4.7 This would be an example of induced innovation—there would be increased profits to be made
from investing in green energy, and we would expect more innovation under these conditions.
4.8 Mass migration out of agriculture might have temporarily increased the real cost of food,
depressing real wages and causing malnutrition and decreased average height.
4.9 At the age of 50, forgone earnings (opportunity costs) are very high and the time to recoup your
investment in medical school is limited compared to someone who goes to school in their 20s or
30s.
4.10 The theory faces challenges in explaining East Asian growth as there are no obvious cultural
changes that have occurred in recent years.

SECTION 8.5: A KEY GOVERNMENTAL ROLE: PROVIDING THE CORRECT

INCENTIVES AND PROPERTY RIGHTS
5.1 False
5.2 d.
5.3 True
5.4 False
5.5 With less investment in human capital, growth will likely be less.
5.6 The reduced supply of educated workers increases the wage paid to educated workers and increases
incentives for acquisition of education. The hypothesis can be tested by comparing the change
in wages paid to educated workers with rates of emigration by educated workers.
5.7 Increased labor income allows parents to buy food in a market instead of producing it at home,
freeing the children from producing food.

Chapter 8 Appendix
1. saving, depreciation
2. b.
3. False
4. Destruction of capital in Japan and Germany reduced capital per worker, causing saving to exceed
depreciation and capital per worker to increase.

5. Increased depreciation rate reduces the equilibrium capital stock and the equilibrium level of output.