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Chapter 10

Long-Run Economic Growth

10.1 The Nature of Economic Growth

Table 10-1 The Cumulative Effect of Economic Growth

Small differences in income growth rates make enormous differences in levels of income over a few decades. Let income be 100 in year 0. At a
growth rate of 3 percent per year, it will be 134 in 10 years, 438 after 50 years, and 1922 after a century. Notice the difference between 2 percent
and 3 percent growth—even small differences in growth rates make big differences in future income levels.

Benefits of Economic Growth

• Rising Average Living Standards

– Economic growth is a powerful means of improving average material living standards.

– Economic growth that raises average income tends to change the whole society’s consumption patterns, shifting away from tangible goods toward
services.

– Economic growth provides the higher incomes that often lead to a demand for a cleaner environment.

Addressing Poverty and Income Inequality

• In recent years, the majority of aggregate income growth in many countries, including Canada, has been accruing to the top earners in the
income distribution.

• While average per capital incomes have been rising, there has also been a rise in income inequality

• Poverty and income inequality are important challenges for public policy
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APPLYING ECONOMIC CONCEPTs

10-2 A Case Against Economic Growth

– Presents a case against continued economic growth, especially in the developed countries

– Growth is not sustainable

– Growth may not increase overall well-being.

Costs of Economic Growth

• Forgone Consumption

– Economic growth, which promises more goods and services in the future, is achieve by consuming fewer goods today. This sacrifice of current
consumption is an important cost of growth.

• Social Costs

– The process of economic growth is disruptive for some businesses and workers. There are social costs from workers’ skills becoming obsolete.

Sources of Economic Growth

• Four major determinants of growth are:

1. Growth in the labour force

2. Growth in human capital

3. Growth in physical capital

4. Technological improvement

• Different theories or economic growth emphasize different sources of growth.

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10.2 Economic Growth: Basic Relationships

• A Long-Run Analysis

– In the simplest short-run macro model, the equilibrium level of real GDP is such that real GDP equals desired consumption plus desired
investment:

Y=C+I

Y – C = I or S = I

– In the short-run, real GDP adjusts to determine equilibrium, in which desired saving equals desired investment.

– In the model’s long-run version, real GDP is equal to Y* and the interest rate adjusts to determine equilibrium.

Investment, Saving, and Growth

• We now add a government sector that purchases goods and services (G) and collects taxes net of transfers (T).

• With real GDP equal to Y* in the long run, desired private saving is equal to:

Private saving = Y* − T − C

• Public saving is equal to the combined budget surpluses of the federal, provincial, and municipal governments.

Public saving = T – G

National saving = NS = Y*−T − C + (T − G)

NS = Y* − C − G

• So for a given level of real GDP in the long run (Y*), an increase in household consumption or government purchases implies a reduction in
national saving.

• The supply curve for national saving and the investment demand curve make up the economy’s market for financial capital.
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Figure 10-2 Investment and Saving in the Long Run

In the long run, the condition that desired national saving equals desired investment determines the equilibrium real interest rate.

Increases in Investment Demand and the Supply of National Saving

• An increase in the supply of national saving (NS) reduces the real interest rate and encourages more investment.

• The higher rate of investment leads to a higher growth rate of potential output
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Figure 10-3(i) Increases in Investment Demand and the Supply of National Saving

Changes in the supply of national saving or the demand for investment will change the equilibrium real interest rate and the rate of growth of
potential output.

Increases in Investment Demand and the Supply of National Saving

• An increase in the demand for investment (I) pushes up the real interest rate and encourages more saving by households.

• The higher rate of saving (and investment) leads to a higher growth rate of potential output.
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Figure 10-3(ii) Increases in Investment Demand and the Supply of National Saving

Changes in the supply of national saving or the demand for investment will change the equilibrium real interest rate and the rate of growth of
potential output.
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Figure 10-4 Cross-Country Investment and Growth Rates, 1961‒2019

• The figure shows a positive relationship between investment rates and growth rates, as predicted by our model.

The “Neoclassical” Growth Model

• The aggregate production function:

GDP = FT (L, K, H)

– L = labour

– K = physical capital

– H = human capital

– T = technology

• The notation FT indicates that the function relating L, K, and H to GDP depends on the state of technology.
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Properties of the Aggregate Production Function

• Key assumptions:

– the aggregate production function displays diminishing marginal returns when any one of the factors is increased on its own.

– constant returns to scale when all factors are increased together.

• For simplicity, we will assume that human capital and physical capital can be combined into a single variable called capital and that technology is
held constant.

Figure 10-5(i) The Aggregate Production Function and Diminishing Marginal Returns

With one input held constant, the other input has a declining average and marginal product.
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Figure 10-5(ii) The Aggregate Production Function and Diminishing Marginal Returns

With one input held constant, the other input has a declining average and marginal product.

Economic Growth in the Neoclassical Model

1. Labour-Force Growth

– In the Neoclassical model with diminishing marginal returns, increases in population (with fixed capital) lead to increases in GDP but an eventual
decline in material living standards.
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2. Physical and Human Capital Accumulation

– Capital accumulation leads to improvements in material living standards, but because of the law of diminishing returns, these improvements
become smaller with each additional increment of capital.

3. Balanced Growth with Constant Technology

– If capital and labour grow at the same rate, GDP will increase.

– In the Neoclassical growth model with constant returns to scale, such balanced growth will not lead to increases in per capita output and
therefore will not generate improvements in material living standards.

4. The Importance of Technological Change

– Technological change is assumed to be exogenous.

– New knowledge can contribute to the growth of potential output, even without capital accumulation or labour-force growth.

– Embodied technical change ‒ technological improvements are contained in the new capital goods.

Should Workers Be Afraid of Technological Change?

• Fear of widespread unemployment caused by technical change is unfounded.

• As long as labour markets continue to adjust to changes in the demand and supply for labour, the overall level of employment will grow in line
with the population, independent of the rate of technological change.

• If overall technological progress leads to an increased demand for skilled workers, the workers most able to adapt to changing economic
conditions are the ones most likely to prosper unlike those without requisite skills.

10.3 Economic Growth: Advanced Theories

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• Endogenous Technological Change

– Research has established that technological change is responsive to economic signals (prices and profits); it is endogenous to the economic
system.

– Growth is achieved through costly, risky, innovative activity that often occurs in response to economic signals.

 Learning by Doing

 Knowledge Transfer

 Market Structure and Innovation

 Shocks and Innovation

Increasing Marginal Returns

• Neoclassical theories of economic growth assume that investment in capital is subject to diminishing marginal returns.

• Some research suggests the possibility of increasing returns that remain for considerable periods of time.

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

– Market-development costs

– The Economics of Ideas

10.4 Are There Limits to Growth?

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• Resource Exhaustion

– The years since WWII have seen a rapid acceleration in the consumption of the world’s resources, particularly fossil fuels and basic minerals.

– The world’s current resources and its present capacity to cope with pollution and environmental degradation are insufficient to accomplish the
rise in global living standards with present technology.

– Most economists agree that absolute limits to growth, based on the assumptions of constant technology and fixed resources, are not relevant.

• Technology changes continually, as do available stocks of resources.

• Advances in technological knowledge bring can increase resource efficiency.

• Technology is constantly advancing, and many things that seemed impossible a generation ago will be commonplace a generation from now.

• Such technological advance makes any absolute limits to economic growth less likely.

Environmental Degradation

• Conscious management of pollution was unnecessary when the world’s population was 1 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.

APPLYING ECONOMIC CONCEPTS(2 of 2)10-3:

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Climate Change and Economic Growth

– Canada has joined many other countries in adopting policies to achieve “net zero emissions” by 2050.

– The most effective policy to reduce the emission of GHGs and shift towards cleaner energy involves placing a higher cost on their emissions, either
through a “carbon tax” or a “cap-and-trade” system.

– Once the economy adjusts to the new and more efficient fuel sources, it is possible that the rate of economic growth would increase.