Econ 102 - Chapter 26

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