C h a p t e r

6 ECONOMIC
GROWTH**

*
* This is Chapter 23 in Economics.

© 2016 Pearson Education, Ltd.

Lecture Notes
Economic Growth

 Economic growth leads to large changes in standards of living from one generation to the next.
 Economic growth rates vary across countries and across time.
 There are different economic theories to explain these variations in growth rates.

I. The Basics of Economic Growth

 The economic growth rate is the annual percentage change of real GDP. This growth rate is equal to:
Real GDP in current year - Real GDP in past year
Real GDP growth rate = ´100
Real GDP in past year
 The standard of living depends on real GDP per person, which is real GDP divided by the population.
The growth rate of real GDP per person can be calculated using the formula above, though substituting
real GDP per person.
 The growth rate of real GDP per person also approximately equals the growth rate of real GDP minus
the population growth rate.
Real GDP can increase for two distinct reasons: The economy might be returning to full employment in an
expansion phase of the business cycle or potential GDP
might be increasing.
 The movement from point A to point B reflects an
expansion phase of the business cycle. It occurs with
no change in production possibilities. Such an
expansion is not economic growth.
 The increase in aggregate production reflected by the
movement from point B on PPF0 to point C on PPF1 is
economic growth—it reflects an expansion of
production possibilities shown by an outward shift of
the PPF.
The Rule of 70 is useful for determining how long it will
take for a variable to double. The Rule of 70 states that the number of years it takes for the level of any
variable to double is approximately 70 divided by the annual percentage growth rate of the variable.

II. Long-Term Growth Trends

Long-Term Growth in the U.S. Economy
The growth of real GDP per person in the United States has fluctuated but has averaged 2 percent per year over
the last century. The growth rate was 1.8 percent prior to the Great Depression and 2.1 percent after World
War II.

Real GDP Growth in the World Economy

Economic growth varies across countries. Among richest countries, there seems to be some convergence of real
GDP per person but most other countries show less evidence of convergence. The “Asian Miracle” is the fast rate
of convergence for Hong Kong, Singapore, Taiwan, Korea, and China.
 WHAT IS ECONOMICS? 167

III. How Potential GDP Grows

Potential GDP is the amount of real GDP that is produced when the quantity of labor employed is the full-
employment amount. To determine potential GDP we use the aggregate production function and the aggregate
labor market.

The Aggregate Production Function

 The aggregate production function is the
relationship between real GDP and the quantity of
labor employed when all other influences on
production remain the same. The figure shows an
aggregate production function.
 The additional real GDP produced by an additional
hour of labor when all other influences on
production remain the same is subject to the law of
diminishing returns, which states that as the quantity
of labor increases, other things remaining the same,
the additional output produced by the labor
decreases. The production function in the figure
shows the law of diminishing returns because its
shape demonstrates that as additional labor is employed, the additional GDP produced diminishes.

The Labor Market

The Demand for Labor
 The demand for labor is the relationship between the quantity of labor demanded and the real wage rate.
 The real wage rate equals the money wage rate divided by the price level. The real wage rate is the
quantity of goods and services that an hour of labor earns and the money wage rate is the number of
dollars that an hour of labor earns.
 Because of diminishing returns, firms hire more labor only if the real wage falls to reflect the fall in the
additional output the labor produces. There is a negative relationship between the real wage rate and the
quantity of labor demanded so, as illustrated in the figure, the demand for labor curve is downward
sloping.
The Supply of Labor
 The supply of labor is the relationship between the quantity of labor supplied and the real wage rate.
 An increase in the real wage rate influences people to work more hours and also increases labor force
participation. These factors mean there is a
positive relationship between the real wage rate
and the quantity of labor supplied so, as illustrated
in the figure, the supply of labor curve is upward
sloping.
Labor Market Equilibrium and Potential GDP
 In the labor market, the real wage rate adjusts to
equate the quantity of labor supplied to the
quantity of labor demanded. In equilibrium, the
labor market is at full employment. In the figure,
the equilibrium quantity of employment is 200
billions of hours per year.

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  Potential GDP is the level of production produced by the full employment quantity of labor. In
combination with the production function shown in the previous figure, the labor market equilibrium in
the figure of 200 billion hours per year means that potential GDP is $13 trillion.

What Makes Potential GDP Grow?

Potential GDP grows when the supply of labor grows and when labor productivity grows.
Growth of the Supply of Labor
 The supply of labor increases if average hours per worker increases, if the employment-to-population
ratio increases, or if the working-age population increases. Of these factors, in the United States over the
past years the first two have offset each other.
 Only increases in the working-age population can cause persisting economic growth. Persisting increases
in the working-age population result from population growth.
 An increase in population increases the supply of labor, which shifts the labor supply curve rightward. The
real wage rate falls and the quantity of employment increases. The increase in employment leads to a
movement along the production function to a higher level of potential GDP.
An Increase in Labor Productivity
 An increase in labor productivity increases the demand
for labor and shifts the production function upward.
 As the top figure illustrates, the increase in the demand
for labor from LD0 to LD1 raises the real wage rate,
from $20 to $30 per hour in the figure, and increases
the level of employment, from 200 billion hours per
year to 300 billion hours per year.
 The bottom figure shows that the production function
has shifted upward, from PF0 to PF1. Combined with the
increase in employment to 300 billion hours per year,
the increase in labor productivity increases potential
GDP from $10 trillion to $15 trillion.
 An increase in labor productivity leads to an increase in
real GDP per person and increases the standard of living.

IV. Why Labor Productivity Grows

Preconditions for Labor Productivity Growth
 The institutions of markets, property rights, and
monetary exchange create incentives for people to
engage in activities that create economic growth and
are preconditions for growth in labor productivity.
Market prices send signals to buyers and sellers that
create incentives to increase or decrease the
quantities demanded and supplied. Property rights
create incentives save and invest in new capital and
develop new technologies. Monetary exchange
creates incentives for people to specialize and trade.
 Persistent growth requires that people face
incentives to create:
 Physical Capital Growth: Saving and investing in
 WHAT IS ECONOMICS? 169

new capital expands production possibilities.

 Human Capital Growth: Investing in human capital speeds growth because human capital is a
fundamental source of increased productivity and technological advance.
 Technological Advances: Technological change, the discovery and the application of new technologies
and new goods, has made the largest contribution to economic growth.

V. Is Economic Growth Sustainable? Theories, Evidence, and Policies.

Classical Growth Theory

Classical growth theory is the view that real GDP growth is temporary and that when real GDP per person
rises above the subsistence level, a population explosion eventually brings real GDP per person back to the
subsistence level.
 A problem with the classical theory is that population growth is independent of economic growth rate.

Neoclassical Growth Theory

Neoclassical growth theory is the proposition that the real GDP per person grows because technological
change induces a level of saving and investment that makes capital per hour of labor grow.
 A technological advance increases productivity. Real GDP per person increases.
 The technological advances increase expected profit. Investment and saving increase so that capital
increases. The increase in capital raises real GDP per person.
 As more capital is accumulated, eventually projects with lower rates of return must be undertaken so
that the incentive to invest and saving decrease. Eventually capital stops increasing so that economic
growth stops.
 The improvement in technology permanently increases real GDP per person.
 A problem with the neoclassical theory is that it predicts that real GDP per person in different nations
will converge to the same level. But in reality, convergence does not seem to be taking place for all
nations.

New Growth Theory

New growth theory holds that real GDP per person grows because of the choices people make in the pursuit
of profit and that growth can persist indefinitely.
 The theory emphasizes that discoveries result from choices, discoveries bring profit, and competition
then destroys the profit. It also stresses that knowledge can be used by everyone at no cost and
knowledge is not subject to diminishing returns.
 The ability to innovate means new technologies are developed and capital accumulated as in the
neoclassical model. The production function shifts upward. Real GDP per person increases.
 The pursuit of profit means that more technological advances occur and the production function
continues to shift upward. Nothing stops the upward shifts of the production function because the lure of
profit is always present.
 The ability to innovate determines how capital accumulation feeds into technological change and the
resulting growth path for the economy. Productivity and real GDP constantly grow.

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The Empirical Evidence on the Causes of Economic Growth
 Economists have studied the growth rate data for more than 100 countries for the period since 1960 and
explored the correlations between the growth rate and more than 60 possible influences on it. The
conclusion of this data crunching is that most of these possible influences have variable and unpredictable
effects, but a few of them have strong and clear effects. Amongst the strongest are:
 International Trade: Nations that are open to trade grow more rapidly
 Investment: Nations that have more investment in human capital and physical capital grow more
rapidly.
 Market Distortions: Nations that have more exchange rate controls, price controls, and black
markets grow more slowly.
 Economic System: Capitalist nations grow more rapidly.
 Politics: Nations that support the rule of law and protect civil liberties grow more rapidly. Nations
that have revolutions, military coups, or fight wars grow more slowly.
 Region: Nations located far from the equator grow more rapidly; nations in Sub-Sahara Africa grow
more slowly.

Policies for Achieving Faster Growth

 Growth theory and the empirical evidence suggest some policies that might stimulate growth:
 Stimulate saving, to increase capital accumulation
 Stimulate research and development, to increase technology
 Improve the quality of education, to increase human capital.
 Provide international aid to developing nations. However studies show that aid tends to get diverted
to consumption. If the objective is to increase growth, then the aid must be carefully directed.
 Encourage international trade, to increase international specialization