One of the most important reasons that both GDP and per capita GDP increase over many years is
growth in productivity
Economic growth
Sustained, long-run increases in the level of real GDP
The benefits of economic growth includes
increases in income
Economic growth provides higher incomes that often lead to a demand for a
cleaner environment, thus leading to higher average living standards not directly captured by measures of per capita GDP.
Because not everyone benefits equally from growth,
even in a growing economy, redistribution policies will be needed if poverty is to be reduced.
Easier for a growing economy to be generous toward its less fortunate citizens - or neighbours- than it is for a
static economy
Economic growth, which promises more goods and services tomorrow, is achieved by consuming fewer goods today. For the economy as a whole, this sacrifice of current consumption is the
primary cost of growth.
The process of economic growth renders some machines obsolete and also leaves the
skills of some workers partly obsolete.
A high growth rate usually requires rapid adjustments in
the labour force
Economic growth has four fundamental determinants:
Growth in the labour force
Growth in human capital
Growth in physical capital
Technological improvement
Growth in the labour force
This may be caused by growth in population or by increase in the fraction of the population that chooses to participate in the labour force
Growth in human capital
Human capital can increase through either formal education or on-the-job training.
Human capital can be though of as the quality of the labour force, but because of its importance we will treat it as a separate factor of production from labour
Human capital
The set of skills workers acquire through formal education and on-the-job training.
Growth in physical capital
The stock of capital (factories, machines etc.) increases only through the process of investment. We include here improvements in the quality of the physical capital
Technological improvement
This is brought about by innovation that introduces new products, new ways of producing existing products, and new forms of organizing economic activity.
The theory of economic growth is a long-run theory. It concentrates on the growth of potential output over long periods of time, not on
short-run fluctuations of output around potential.
We can take the level of output as given (Y*) and use the condition that desired saving equals desired investment to determine the equilibrium growth and use the condition that desire saving equals desired
investment to determine the equilibrium real interest rate
National saving is the sum
of private saving and public (government saving
Disired saving is the difference between
disposable income and desire dincome
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 is therefore equal to
NS = Y* - T - C + (T-G)
=
NS = Y* - C - G
An increase in household consumption or government purchases implies a
reduction in national saving
National saving curve is upward sloping because
an increase in the interest rate is assumed to lead household to reduce their current consumptions, especially on big-ticket items and durable goods, such as cars, furniture, and appliances, that are often purchased on credit.
NS curve is steep suggesting that
household consumption responds only modestly to changes in the real interest rate.
Investment demand curve is downward-sloping because
All components of desired investment (capital) are negatively related to the real interest rate, because, whether the investment is financed by borrowing or by using the firm's retained earnings, the real interest rate reflects the opportunity cost of usi
In short-run model, economy is in equilibrium when desired saving equals desired investment.
We modify these settings in only two ways
We added government
We are holding real GDP constant at Y* and letting the equilibrium condition that desired saving equal desired investment determine the real interest rate in the market for loanable funds.
In the long-run version of our macro model, with real GDP equal to Y*, the equilibrium interest rate is determined where
desired national saving equals desired investment
If I is above I*, the amount of desired saving exceeds the amount of desired investment, and this excess supply of loanable funds pushes down the
price of credit - the real interest rate.
If interest rate is below I*, the quantity of desired investment exceeds the quantity of desired saving, and this excess demand for loanable funds pushes
up the real interest rate.
The increase in the supply of national saving could happen either because
household consumption (C) falls or because government purchases (G) fall (or because T rises, which reduces C)
A decline in either C or G means that national saving rises at any real interest rate and so the NS curve shifts
to the right
The increase in the supply of national saving leads to an excess supply of loanable funds and thus to a decline in the
real interest rate
As I.R. falls, firms decide to
undertake more investment projects and the economy moves from the initial equilibrium to the new equilibrium
Substitution effect
When your interest rates go up
Attractive to save than consume now
Income effect
As interest rate goes up
don't need to save as much to consume a certain amount in the future
At the new equilibrium, more of the economy's resources are devoted to investment than before, and thus the country's capital stock is
rising at a faster rate.
Higher rate of investment therefore leads to a
higher future growth rate of potential output.
In the long run, an increase in the supply of national saving reduces the real interest rate and encourages more investment. The higher rate of investment leads to a
higher future growth rate of potential output.
The increase in desired investment might be caused by technological improvement that
increases the productivty of investment goods or by a government tax incentive aimed at encouraging investment.
Increase in invesment demand creates an excess demand for loanable funds and therefore leads to
a rise in the real interest rate
At new equilibrium
both the ral interst rate and the amount of investment are higher than at the inital equilibrium
In the long run, an increase in the demand for investment pushes up the real interst rate and encourages more saving by households. The higher rate of savings (and investment) leads to
a higher future growth rate of potential output.
Alpha =
Income paid to workers as a fraction of GDP
1-alpha
Neoclassical growth theory
based on the idea that these four forces (labour, physical capital employed, the quality of labour's human capital, the state of technology)) of economic growth can be connected by what is called the aggregate production function
MPL or MPN
additional output from an extra worker
deltaFt / deltaL
Aggregate production function
The relationship between the total amount of each factor of production employed in the nation's total GDP
The aggregate production function can be expressed as
GDP = FT(L,K,H)
L = labour
K = physical capital
H = labour's human capital
GDP = nation's total level of output
FT = the function relating L,K, and H to GDP depends on the state of technology.
For a given state of technology (T), changes in
either L,K, or H will lead to changes in GDP.
For given values of L, K, and H, changes in T will lead to
changes in GDP
The production function - indicated by FT - tells us how much GDP will be
produced for given amounts of labour and physical capital employed, given levels of human capital, and a given state of technology.
When discussing long-run economic growth, we focus on the
changes in potential output
We therefore interpret GDP n the aggregate production function as
potential output
The key =aspects of the Neoclassical theory are that
the aggregate production function displays diminishing marginal returns when any one of the factors is increased on its own and constant returns to scale when all factors are increased together (and in the same proportion).
For simplicity, we combine human capital and physical capital into single variable called
capital
and that technology is
held constant
We therefore focus on the effects of
changes in K or L
Law of dimishing marginal returns
The hypothesis that if increasing quantities of a variable factor are applied to a quantity of fixed factors, the marginal product of the variable factor will eventually decrease
Suppose that labour force grows hile stock of capital remains constant
More and more people go to work using a fixed quantity of capital.
Law of diminishing marginal returns tells us that
the employment of additional workers will eventually add less to total output than the previous worker did.
According to the law of diminishing marginal returns, whenever
equal increases of one factor of production are combined with a fixed amount of another factor, the increment to total production will eventually decline
With one input held constant, the other input has a
declining average and marginal product.
Other main property of Neoclassical aggregate production function is that it displays
constant returns to scale
Constant returns to scale
A situation which output increases in proportion to the change in all input as the scale of production is increased
If L and K both increase by 10%, then
GDP will also increase by 10%
4 fundamental sources of growth
growth in labour force, human capital, physical capital and technological improvement.
If both the marginal product and average product of labour are falling
although economic growth continues in the sense that output is growing, material living standards are actually falling because average GDP per person is falling (real GDP is growing more slowly than the population).
If we are interested in growth in livin
In the neoclassical growth model with diminishing marginal returns, increases in
population (with a fixed stock of capital) leads to increases in GDP but an eventual decline in material living standards
Growth in phsical cap
...
ital occurs whenever there is
positive (net) investment in hte economyh.
How does human capital accumlate?
Health
Technical training, which also leads to better adaptability and, hence, more productive.
In the neoclassical model, capital accumulation leads to improvements in living standards, but because of the law of diminishing marginal returns, these improvements become
smaller with additional increment of capital
Balanced growth with constant technology
Labour and capital grow at the same rate
Because increases in living standard are determined largely by increases in per capita output, it is clear that
balanced growth is unable to explain rising living standards
If capital and labour row at the same rate, GDP will increase, But 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 living standards
Increases in labour and capital together cannot explain
increases in per capita income
Embodied technical change
Technical change that is intrinsic to the particular capital goods in use.
The increase in productive capacity created by installing new and better capital is called
embodied technical change
Many innovations are embodied in either
physical or human capital.
These innovations cause continual changes in the techniques of production and in the nature of what is produced. Embodied technical change leads to
increase in potential output even if the amounts of labour and capital are held constant.
The Solow Residual
the amount of growth in GDP that cannot be accounted for by growth in the labour force or by growth in the capital stock.
Since Solow was thinking about changes in GDP as having only three possible sources, changs in capital, labour and technology - the
Technical Change
A technical change is a term used in economics to describe a change in the amount of output produced from the same amount of inputs. A technical change is not necessarily technological as it might be organizational, or due to a change in a constraint such
Endogenous Technological Change (Endogenous growth model)
Learning by doing
Knowledge Transfer
Market structure and innovation
Shocks and innovation
Learning by doing
Innovation involves a large amount of "learning by doing" at all of its stages.
Best innovation-managing systems enrouge such "feedbacK" from the more applied steps to the purer researchers and from users to designers
Knowledge transfer
The diffusion of technological knowledge from those who have it to those who want it is not costless
Most skills cannot be "embodied" in the machine themselves, instruction books, or blueprints. The needed knowledge is tacit in the sense that it can be ac
Market structure and innovation
Because it is highly risky, innovation is encouraged by strong rivalry among firms and discouraged by monopoly practices.
Policies that make firms more competitive - either by lowering protective tariffs or by reducing domestic regulations that hamper com
Shocks and Innovation
Shcks sometimes provide innovation
Sharp rise in price of one input can raise costs and lower the value of output per person for some time
But it may lead to a wave of innovations that reduce the need for this expensive input, and, as a side effect, great
New growth theories emphasize the possibility of increasing returns that remain for considerable periods of time
As investment in some new area, product, or production technology proceeds through time, new increments of investment are more productive than previous increments.
For three reasons, there may be important costs associated with the initial development of the market;
These costs result in increasing marginal returns to investment
Investment in early stages of development may create
new skills and attitudes in workforce that are then available to subsequent firms, costs are therefore now lower.
Each new firm may find environment more favourable to its investment because of
physical infrastructure that has been created by those who came before it
First investment in new product will encounter production problems that, once overcome,
cause fewer problems to subsequent investors.
Returns to later investment are greater than returns in initial investment because
economic environment becomes more fully developed over time
Successive increments of investment associated with an innovation often yields a range of increasing marginal returns as costs that are incurred in earlier investment expenditure provide publicly available knowledge and experience and as costumer attitude
...
Ideas are also not necessarily subject to
diminishing marginal returns
As our knowledge increases, each increment of new knowledge does not inevitably add less to our productive ability than each previous increment.
NeoC GT gave economies the name "the dismal science" by emphasizing diminishing marginal returns under conditions of given technology. The new growth theories are more optimistic because they emphasize the
unlimited potential of knowledge-drien technological change.
Advances in technological knowledge typically comes with an
increase in the economy's 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
...
Conscious management of pollution was unnecessary when the world's population was 1 billion people, but such management has now become a pressing matter
...
Benefits of growth
Better living standards
Costs of growth
Consume less now
Some people worse off (lay-off)
Degradation of the environment