Macroeconomics / Makroekonomia

Block 1
Chapter 23
GDP & Economic Growth
Summer 2024

After studying this chapter, you will be able to:

 Understand GDP Growth in more detail

 Explain what makes potential GDP growth

 Explain the sources of labor productivity growth

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 How Potential GDP Grows

Economic growth occurs when real GDP increases.

* This is a yearly percentage increase (Consecutive)
But a one-shot increase in real GDP or a recovery from
recession is not economic growth.
* The recovery is a period in which the economy produces
to regain previous levels of output prior to the recession
Economic growth is the sustained, year-on-year increase
in potential GDP.
* Achieved under conditions of full employment and
expansion by engaging input factors to production

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How Potential GDP Grows

What Determines Potential GDP?

Potential GDP is the quantity of real GDP produced when
the quantity of labor employed is the full-employment
quantity.
* Real GDP and Full-Employment = Potential GDP
To determine potential GDP we use a model with two
components:
 An aggregate production function
 An aggregate labor market

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 How Potential GDP Grows
All other factors are constant
Aggregate Production
Function (APF)
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 labor
increases real GDP.
• Real GDP increases steeply up to point A
• Adding more labour beyond point A results in diminishing output
© 2019 Pearson Education

How Potential GDP Grows

Aggregate Labor Market
The demand for labour shows the quantity of labor demanded
and the real wage rate.
* Is demand higher when the real wage rate is higher?
* In this case you are a company
The supply of labor shows the quantity of labour supplied and the
real wage rate.
* Is supply higher when the real wage rate is lower?
* In this case you are a worker
The labour market is in equilibrium at the real wage rate at which
the quantity of labor demanded equals the quantity of labour
supplied. © 2019 Pearson Education

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 How Potential GDP Grows

Figure 23.7 illustrates

labour market equilibrium.
Labour 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 labour and the
real wage rate falls.

* As the real wage increases above $35 per hour, more people are
interested in working. The supply of labour (LS) increases.
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How Potential GDP Grows

At a real wage rate below

$35 an hour, there is a
shortage of labour and the
real wage rate rises.

At the labour market

equilibrium, the economy
is at full employment.

At wage rates below $35 per hour fewer people are prepared to
offer their services. The real wage rate needs to go up.
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 How Potential
GDP Grows
LD = LS at
Potential GDP $35 per hour
The quantity of real GDP
produced when the
economy is at full
employment is potential
GDP.
The economy is at When LD = LS, full
full-employment when employment is
200 billion hours of labour achieved and potential
GDP
are employed.
Potential GDP is $18 trillion.

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How Potential GDP Grows

What Makes Potential GDP Grow?

We begin by dividing real GDP growth into the forces that
increase:
• Both of the following variables are determinants of real
GDP and real GDP per capita growth, but what influences
their change?

 Growth in the supply of labour?

 Growth in labor productivity?
* Which of the two above variables is more important in
raising real GDP and real GDP per capita growth?
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 How Potential GDP Grows
Growth in the Supply of Labor
Aggregate hours, the total number of hours worked by all the
people employed, change as a result of changes in:
1. Average hours per worker
What do you think determines the number of hours that people
can work? Think about some of the country-level conditions.
2. Employment-to-population ratio (increase / decrease)
3. The working-age population growth (increase / decrease)
Population growth increases aggregate hours and real GDP,
but to increase real GDP per person, labour must become
more productive.
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How Potential GDP Grows

The Effects of Population Growth

An increase in population increases the supply of labour.
With no change in the demand for labour, the equilibrium real
wage rate falls and the aggregate hours increase.
As aggregate hours increase, potential GDP increases.

• Immigration increases the size of the population + labour

• It increases real GDP, but lowers real GDP per head
• It also lowers the real wage rate
• Is immigration a bad thing? Answer: That depends…
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 How Potential GDP Grows

Figure 23.9(a) illustrates

the effects of population
growth in the labour
market.
The labour supply curve
shifts rightward.
The real wage rate falls …
and aggregate hours
increase.

Note: As the real wage rate falls the total number of hours increases.
* Separately, but relatedly, a lower wage rate is attractive for potential
foreign investors, which many countries are in competition for.
© 2019 Pearson Education

How Potential GDP Grows

Limitations What’s happening here?
As aggregate hours
increase, potential GDP
increases.
Because of the
diminishing returns, the
increased population …
increases real GDP, …
but decreases real GDP
per hour of labour.

Adding more and more workers eventually reduces the

productivity of labour per hour. The law of diminishing returns.
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 How Potential GDP Grows

Growth of Labor Productivity (This is important)

Labour productivity is the quantity of real GDP produced
by an hour of labor.
Labour productivity equals real GDP divided by aggregate
labor hours.
If labour becomes more productive, firms are willing to pay
more for a given number of hours so the demand for labor
increases.
For reference: the OECD provides data on the number of
hours worked and the productivity of labour in $ terms per
hour. You could compare these values across countries.
© 2019 Pearson Education

How Potential GDP Grows

Figure 23.10 shows the

effect of an increase in
labour productivity.

The increase in labour

productivity shifts the
production function Constant
upward.

Question: Holding the billions of hours worked per year

constant, what causes real GDP to increase?
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 How Potential GDP Grows

In the labour market:

An increase in labour
productivity increases the
demand for labour.
With no change in the
supply of labor, the real
wage rate rises …
and aggregate hours
increase.

How do firms react to increases in labour productivity, holding the

supply of labour constant? What are the effects?
© 2019 Pearson Education

How Potential GDP Grows

And with the increase in

aggregate hours,
potential GDP increases
from B to C.

Under conditions
where the supply of
labour is fixed, firms
not only raise the real
wage rate, but the
labour force works
more hours.

© 2019 Pearson Education

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 Why Labor Productivity Grows

Preconditions for Labor Productivity Growth

The fundamental precondition for labor productivity growth
is the incentive system created by firms, markets, property
rights, and money.
With preconditions for labour productivity growth in place,
three things influence its pace:
 Physical capital growth
 Human capital growth
 Technological advances

These three factors are essential in raising labour productivity

© 2019 Pearson Education

Why Labor Productivity Grows

Physical Capital Growth
The accumulation of new capital increases capital per worker and
increases labour productivity.
* Increases in the K/L ratio increases labour productivity
* Car production in Germany: 70/30 (approximate)

Human Capital Growth

Human capital acquired through education, on-the-job training,
and learning-by-doing is the most fundamental source of labour
productivity growth.
* Investment in education, research and technology is also key to
remaining competitive in the global economy.
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 Why Labor Productivity Grows

Technological Advances
Technological change—the discovery and the application
of new technologies and new goods—has contributed
immensely to increasing labour productivity.
Figure 23.11 on the next slide summarizes the process of
growth.
It also shows that the growth of real GDP per person
depends on real GDP growth and the population growth
rate. Think about what this means.

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Why Labor Productivity Grows

• The interaction of labour supply and labour demand

determines the real wage rate.
• Countries with an abundant supply of labour often employ
more workers and lower the real wage rate and vice-versa.
© 2019 Pearson Education

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 Growth Theories, Evidence,
and Policies
Policies for Achieving Faster Growth
Growth accounting tells us that to achieve faster economic
growth we must either increase the growth rate of capital
per hour of labour or increase the pace of technological
change.
The main suggestions for achieving these objectives are
Stimulate Saving
Saving finances investment. So higher saving rates might
increase physical capital growth.
Tax incentives might be provided to boost saving.

© 2019 Pearson Education

Growth Theories, Evidence,

and Policies

© 2019 Pearson Education

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 Review Questions

1. What does the standard of living depend on?

2. The supply of labour is defined as the relationship between what?
3. What happens when the amount of capital per worker increases?
4. What happens when there is an increase in the aggregate number of hours worked?
5. Which variable needs to increase for economic expansion to occur?
6. If your country builds new hospitals then which component of GDP would you expect to rise?
7. Which two variables are used to calculate labour productivity?
8. Which variable would we look at to see whether a recession is occurring?
9. What influences the pace of labour productivity growth?
10. What does the economic growth rate tell us?

© 2019 Pearson Education

Growth Theories, Evidence,

and Policies
Theories of growth:

 Classical growth theory

 Neoclassical growth theory

 New growth theory

Please read up on these three schools of thought on theories of growth.

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