Potential GDP and Economic Growth

Potential GDP and Economic

Growth

Chapter

1CHAPTER OUTLINE

1. Explain what determines potential GDP.

A. The Three Main Schools of Thought1. Classical Macroeconomics2. Keynesian Macroeconomics3. Monetarist Macroeconomics

B. Today’s ConsensusC. The Road AheadD.Potential GDPE. The Production FunctionF. The Labor Market

1. The Demand for Labor2. The Supply of Labor3. Labor Market Equilibrium4. Full Employment and Potential GDP

2.Define and calculate the economic growth rate, and explain the implications of sustained growth.

A. Calculating Growth RatesB. The Magic of Sustained Growth

3.Explain the sources of labor productivity growth.A. Labor ProductivityB. Saving and Investment in Physical Capital

1. Capital Accumulation and Diminishing Marginal Returns2. Illustrating the Law of Diminishing Marginal Returns

C. Expansion of Human Capital and Discovery of New Technologies1. Illustrating the Effects of Human Capital and Technological Change

D.Combined Influences Bring Labor Productivity GrowthE. What Keeps Labor Productivity Growing?

4.Describe policies that speed economic growth.A. Preconditions for Economic Growth

1. Economic Freedom

© 2015 Pearson Education, Inc.

280 Part 5 . UNDERSTANDING THE MACROECONOMY

2. Property Rights3. Markets

B. Policies to Achieve Faster Growth1. Create Incentive Mechanisms2. Encourage Saving3. Encourage Research and Development4. Encourage International Trade5. Improve the Quality of Education

C. How Much Difference Can Policy Make?

What’s New in this Edition?Chapter 17 features updated data throughout, but no major content revisions.

Where We AreFirst we preview different approaches to macroeco-nomics to give the students a grasp of where they are going and why. Then we explain the forces that determine potential GDP, which is the production function in combination with the labor market. We also explore economic growth, and what policies can be used to encourage more rapid growth. The tech-nical models of economic growth—the classical model, the neoclassical model, and the new growth theory—are not included.

Where We’ve BeenThe previous three chapters were essentially an in-troduction to macroeconomics. We explained basic concepts, such as GDP and the Consumer Price In-dex. We also examined data for the U.S. economy showing how GDP, the unemployment rate, and on the inflation rate have changed over time.

Where We’re GoingThis chapter starts the study of the macroeconomy, culminating in Chapter 20 with an examination of fiscal and monetary policy.

IN THE CLASSROOM

Class Time NeededThe material in this chapter can be covered in two and one half to three class sessions. Do not skimp on the very first material, dis-


Chapter 17 . Potential GDP and Economic Growth 281

cussing different approaches to macroeconomics, because this mate-rial serves as a valuable introduction to the students that will help them throughout the entire section “Understanding the Macroecon-omy.”

An estimate of the time per checklist topic is:

17.1 Potential GDP—50 to 100 minutes

17.2 The Basics of Economic Growth—20 to 30 minutes

17.3 Labor Productivity Growth—40 to 50 minutes

17.4 Achieving Faster Growth—30 to 40 minutes

Classroom Activity: Economic growth can be an exciting topic for students if the lecture is motivated by examples that students can relate to on a personal level. You can provide the table below indicating income per person (in 2000 dollars) starting in 1800. The 1800, 1900, and 2000 figures are actual data; obviously the 2100 and 2200 are hypothetical data and represent the incomes if economic growth continues at the same average pace as it has since 1800.Ask your class what kind of life people had in the year 1800 with an average in-come of $762 a year in current dollars. Answers will vary but many students are likely to respond that life was quite hard. Transportation was limited to horses, and meals were all prepared at home from scratch and cooked over an open fire. Medical care was quite meager (even the stethoscope was sixteen years away in the making) and entertainment was limited to books and song. In fact, very few people actually owned a book besides the Bible in 1800! By 1900 life was a bit better. The advent of the railroad made transportation much more practical and efficient. The potbelly stove was now available to cook meals and we had even conquered a few diseases along the way.

Year

Average income(2000 dollars per per-

son per year)1800 7621900 5,5212000 40,0002100 290,0002200 2,100,000



CHAPTER LECTURE

Macroeconomic Approaches and PathwaysThere are three major approaches to macroeconomics:

Classical macroeconomics is a theory about how a market economy works and why it experiences economic growth and fluctuations. This theory started with Adam Smith, David Ricardo, and John Stuart Mill in the 18th and 19th centuries, though classical economists are still prevalent today. The view of this approach is that markets work well and, although the economy will fluctuate in business cycles, nothing the government can do will improve on the performance. During the Great Depression the unemployment rate rose to 25 percent

and economic growth was nonexistent. Classical macroeconomics fell into disrepute as it predicted that the Great Depression would end quickly, but it did not do so.

Keynesian macroeconomics is a theory about how a market economy works that stresses its inherent instability and the need for active govern-ment intervention to achieve full employment and sustained economic growth. This theory started with John Maynard Keynes in the middle of the Great Depression in 1936 and argued that inadequate spending by house-holds and businesses (private spending) that causes recession can be coun-tered by increased government spending. Keynesian macroeconomics was the mainstream theory by the 1960s and 1970s. Keynesian theory focused on the short run. But in the 1970s, long-run is-

sues (such as economic growth) emerged as important. Monetarist macroeconomics is the view that the market economy works

well, that aggregate fluctuations are a natural consequence of an expanding economy, but expands on classical theory by arguing that fluctuations in the quantity of money also bring the business cycle. Milton Friedman was the most prominent monetarist. While most economists agree that the quantity of money plays a role in

economic fluctuations, few believe that it is the sole cause of the business cycle.

Today’s ConsensusToday’s consensus combines insights and ingredients from the three schools of thought.

Classical macroeconomics describes the economy at (or close to) full employ-ment, but fails to explain economic performance in the face of a major slump in spending seen during a recession or depression.

Keynesian macroeconomics explains economic performance in a recession or depression and offers policy options (increases in government spending and/or tax cuts) to help restore full employment.

Monetarist macroeconomics expands the Keynesian story by emphasizing that a contraction in the quantity of money brings higher interest rates, re-sulting in spending cuts that can create a recession. Increasing the quantity of money and lowering interest rates can help increase spending and restore



full employment. Monetarists also argue that tying monetary growth to the growth of production possibilities can keep inflation in check.

Part of today’s consensus is that the long-term problem of economic growth is more important than the short-term problem of economic fluctuations. While the income lost during a recession is serious, because the losses are highly concentrated on those who are unemployed, that lost income is far less than the income lost from slower economic growth.

This book is based on the new consensus. It starts by examining real factors, the forces that determine real GDP at full employment and the pace of eco-nomic growth. Then it studies money and the forces that bring inflation. Fi-nally it looks at the ongoing debate about government macroeconomic policy.

17.1 Potential GDP Potential GDP is value of real GDP when all the economy’s factors of pro-

duction—labor, capital, land, and entrepreneurial ability—are fully employed. Potential GDP is the level of real GDP that the economy produces when it is at full employment. Actual real GDP fluctuates around potential GDP, so po-tential GDP is the sustainable upper limit of production. Fluctuations in real GDP around potential GDP is largely influenced by the quantity of labor em-ployed.

The Production Function The production function is a rela-

tionship that shows the maximum quantity of real GDP that can be produced as the quantity of labor employed changes and all other in-fluences on production remain the same. The figure shows a produc-tion function. The production function shows

diminishing returns, the ten-dency for each additional hour of labor employed to produce a successively smaller additional amount of real GDP. The pro-duction function in the figure shows diminishing returns be-cause its shape demonstrates that as additional labor is em-ployed, the additional GDP pro-duced diminishes. Diminishing returns occurs because along the produc-tion function each additional unit of labor works with the same amount of capital and other resources.

The Labor Market The quantity of labor demanded is the total labor hours that all the firms

in the economy plan to hire during a given time period at a given real wage



rate. The demand for labor is the relationship between the quantity of labor demanded and the real wage rate when all other influences on firms’ hiring plans remain the same. The real wage rate is the nominal wage rate divided by the price level. Firms maximize their profit by hiring the quantity of labor so that the real

wage rate equals the extra output produced by an additional worker. Be-cause of diminishing returns, the extra output diminishes as more work-ers are hired. As a result, there is a negative relationship between the real wage rate and the quantity of labor demanded and the demand for la-bor curve is downward sloping.

The quantity of labor supplied is the number of labor hours that all the households in the economy plan to work during a given time period at a given real wage rate. The supply of labor is the relationship between the quantity of labor supplied and the real wage rate when all other influences on work plans remain the same. There is a positive relationship between the real wage rate and the quan-

tity of labor supplied. The positive relationship arises because an increase in the real wage rate influences people to work more hours and also in-creases labor force participation. So the labor supply curve is upward sloping.

Labor supply changes and the labor supply curve shifts when income taxes change (higher income taxes decrease the supply of labor and shift the labor supply curve leftward) and unemployment benefits (more gener-ous unemployment benefits lead to longer job search, which decreases the supply of labor and shifts the labor supply curve leftward).

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 employ-ment.

Potential GDP is the level of pro-duction produced by the full em-ployment quantity of labor. In the figure, the equilibrium

quantity of employment is 200 billions of hours per year. In combination with the produc-tion function shown in the pre-vious figure, potential GDP is $13 trillion.

Lecturer Launcher: Students sometimes understand the definition of potential GDP but have a hard time seeing it in practice. You may want to spend some time comparing the United States to the Eurozone using the Eye on the Global



Economy and Eye on U.S. Potential GDP boxes. If you talked about global differ-ences in unemployment in chapter 15, discussing higher unemployment benefits and less flexible labor markets for France, Germany, and Italy, you can now use this information again to highlight how this determines differences in potential GDP. Use the Eye on the Global Economy box to describe the labor market dif-ferences. Mention that the higher unemployment benefits in Europe reduce the opportunity cost of job search. Together with differences in attitudes toward leisure, Europeans work an average of 30.5 hours per week compared to Ameri-cans’ 34 hours per week. Then link this discussion to the calculation of potential GDP. This will help to cement ideas that potential GDP is not some mythical number that is the same for each economy but that it depends on the underlying differences across countries, which include both labor market differences and productivity differences.

17.2 The Basics of Economic Growth

Lecture Launcher: Ask the students if the economy will grow dramatically differ-ently if the growth rate is 3 percent or 5 percent. Students will probably say that it won’t make much difference. But, counter that over longer periods of time it can make a substantial difference. You can demonstrate this fact with a few sim-ple calculations. Assume a hypothetical economy that starts off with real GDP of $100 billion. The numbers in the table below are the size of the economy in bil-lions of dollars. What is instructive here is that small changes in the growth rate over short periods of time do not have much of an impact on the size of the econ-omy. But small changes in growth rate over longer periods of time do. You can point out that the economy is almost at the same level at 5 percent growth after 10 years as it is at 3 percent after 20 years. In fact there is a very good historical example that you can point to that helps illustrate just how important small dif-ferences in economic growth can be. Since World War II the U.S. economy has grown at an average rate of approximately 3 percent a year. During the so-called slow down of the 1970s the growth rate dropped by as much as half of its histori-cal rate. Economists have estimated that this slow down has cost our economy at least three trillion dollars in lost output! You can explain that this is output that is irretrievably lost. That is, we cannot get it back

Calculating Growth Rates The economic growth rate is the annual percentage change of real GDP.

The growth rate of real GDP equals:


Year3 percentgrowth

rate

5 percent growth

rate

8 percent growth

rate5 $115.92 $127.63 $146.93

10 $134.39 $162.89 $215.8920 $180.61 $265.33 $466.1040 $326.20 $704.00 $2,172.45


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 equals:

Growth rate of real GDP per person = Growth rate of real GDP – Growth rate of population.

The Magic of Sustained Growth The Rule of 70 demonstrates the magic of economic growth. 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 vari-able. Sustained growth of real GDP per person can transform a poor society

into a wealthy one.

17.3 Labor Productivity GrowthReal GDP grows when the quantities of the factors of production grow or when per-sistent advances in technology make them increasingly productive. Our standard of living improves only if growth occurs because of increases in labor productivity.

Labor Productivity Labor productivity is the quantity of real GDP produced by one hour of la-

bor. Labor productivity = (Real GDP) (Aggregate hours). Rearranging, real GDP

= (Aggregate hours) (Labor productivity). Using the rearranged formula shows that growth in real GDP can be divided into growth in aggregate hours and growth in labor productivity.

The growth of labor productivity is influenced by saving and investment in physical capital, expansion of human capital, and discovery of new technolo-gies.

Saving and Investment in Physical Capital More saving and investment in physical capital increases labor productiv-

ity. The law of diminishing returns states that if the quantity of capital is

small, an increase in capital brings a large increase in production; and if the quantity of capital is large, an increase in capital brings a small in-crease in production. This fact about capital means that saving and in-vestment in additional capital will not bring sustained economic growth without an accompanying expansion of human capital and technological change.

The productivity curve shows how real GDP per hour of labor changes as the quantity of capital per hour of labor changes. As capital per hour of labor increases, labor productivity increases by ever smaller amounts and eventually stops rising.



Expansion of human capital: Human capital is the accumulated skills and knowledge of people. Human capital is the most fundamental source of economic growth because it directly increases labor productivity and is the source of the discovery of new technologies. Human capital comes from education and training, job experience, and health and diet.

Discovery of new technologies: New technologies increase labor produc-tivity. Often these new technologies require new and better capital, such as personal computers replacing typewriters.

The expansion of human capi-tal and the discovery of new technologies shift the produc-tivity curve upward, as illus-trated in the figure by the up-ward shift from PC0 to PC1. (Increases in capital per hour of labor lead to movements along the productivity curve.

17.4 Achieving Faster Growth

Preconditions for Economic Growth Three necessary preconditions for economic growth are:

Economic freedom: Economic freedom is a condition in which people are able to make personal choices, their private property is protected, and they are free to buy and sell in markets.

Property rights: Property rights are the social arrangements that gov-ern the protection of private property. Clearly established and enforced property rights provide people with the incentive to work and save.

Markets: Markets enable people to trade and to save and invest. Markets cannot operate without property rights.

These three preconditions for economic growth are necessary for growth but do not guarantee that economic growth will occur. For growth to occur and to persist, people need incentives to save and invest, to accumulate human capital, and to develop new technologies.

The three preconditions for growth—economic freedom, property rights, and mar-kets are all essential to create acceptable levels of risk and low enough transactions costs to justify investment, specialization, and exchange. If you want to spend time on it, you can generate an interesting discussion on whether what matters is the



particular system of property rights, or just that they be clear, certain, and enforce-able with reasonable cost—the concept of the rule of law. Most students have never realized that property rights are highly varied, and many fast growing economies have nothing like U.S. absolute property rights in land, for example.

Policies to Achieve Faster Growth Government policies to achieve economic growth must provide people with

the incentives to save and investment, accumulate human capital, and de-velop new technologies. Create Incentive Mechanisms: Enforce property rights with a well-func-

tioning legal system. Encourage Saving: Increased saving can increase the growth of capital

and stimulate economic growth. East Asian countries have the highest growth rates and saving rates; some African economies have the lowest saving rates and the lowest economic growth rates.

Encourage Research and Development: More research and development creates technological advances. Governments can direct public funds to-ward financing basic research.

Encourage International Trade: International trade extracts all the avail-able gains from specialization and exchange.

Improve the Quality of Education: The social benefits of education go be-yond the benefits accrued to the individuals who receive the education. The government can help by financing more basic education to raise skills in language, math and science.

Is there convergence or divergence in standards of living amongst nations? What is the role of economic growth for economic inequality? These are highly controversial questions. Most anti-globalization activists treat it as incontrovertible that economic growth creates higher inequality. But this view is likely incorrect. First, there has been a general convergence of standards of living for human beings over the past 50 years. This is in part the result of economic growth in China with a population that accounts for close to one-fifth of humanity. Second, while some nations have fallen behind, those less developed countries that have grown fastest are those that have been most involved in “globalization” in the sense becoming more integrated into global markets for goods and capital. The policy suggestions of the anti-globalization movement, such as reducing foreign trade and international capital mobility or even abandoning capitalism, property rights, and markets are the policies that are cur-rently most practiced in countries that have grown the slowest. This result might not be a coincidence.

How Much Difference Can Policy Make? Change brings gains to some and losses to others. Because societies balance

the interests of one group against the interests of another group, change is slow to occur and so changes that would increase the economic growth rate are slow to occur. And the government cannot simply dial up large changes in the economic growth rate.



USING EYE ON THE U.S. ECONOMY

The Lucas Wedge and the Okun GapMost students are aware of the problems of recessions, especially if the economy happens to be in a recession when you teach the class. However, virtually no students are aware of the issues surrounding slower economic growth. This Eye is an outstanding chance to make clear to your students why an increasingly large number of econo-mists are coming to believe that understanding what factors can lead to an increase in economic growth is significantly more important than understanding what factors can moderate business cycles. The Lucas wedge figure makes clear the tremendous “lost output” from slower economic growth. To make this potentially abstract figure more real, ask the students what they would do if they had an extra $406,000 (or since most of your students probably haven’t been around since 1970, if each of their parents had an extra $406,000)? What would they buy with the extra purchasing power? Then point out to them that this happy problem is what could have confronted them if real GDP per person in the U.S. economy had continued to grow at 2.8 percent per year rather than slowing to 2.0 percent per year. Con-fronted with this concrete example, most students immediately under-stand the importance of economic growth!

USING EYE ON THE GLOBAL ECONOMY

Potential GDP in the United States and European UnionThis Eye on the Global Economy can really springboard students to think deeply about cultural differences and how different cultures and different people have different values. As the Eye points out, the average work week in the major European economies is approximately 13 percent shorter than in the United States (4 hours less per week, which translates to 208 hours a year). For partially this reason, potential GDP in the United States is much greater than potential GDP in the Europe and so U.S. citizens consume more material goods than their European cousins. But European citizens enjoy more leisure hours per week. Clearly the United States and Europe have opted for different tradeoffs between consuming goods and services versus consuming leisure. You can ask you students why they think this difference exists? You also can ask your students which tradeoff they prefer: More goods and services and less leisure time or more leisure time and fewer goods and services? This exercise can serve as a reminder of the limitations of focusing too heavily on GDP as a measurement of standard of living in an economy. Finally, ask them if they think this difference will persist or will the United States become more like Europe or Europe more like the United States?



USING EYE ON U.S. POTENTIAL GDP

Why Do Americans Earn More and Produce More Than Euro-peans? Be sure to tie this Eye on U.S. potential GDP to the previous Eye on the Global Economy, “Potential GDP in the United States and the Eu-ropean Union.” The earlier Eye on the Global Economy asserted some facts about the labor markets in the United States and Europe. This Eye goes deeper to explain why these differences exist. Point out to the students that this enhanced understanding is the role of econom-ics: Rather than merely recite data, economics endeavors to acquire a deeper understanding of the phenomena under study and these mod-els your students are learning are the ones that are used to help orga-nize and illustrate this understanding.

USING EYE ON THE PAST

How Fast Has Real GDP per Person Grown?

A good motivator for the discussion of the data included in this study might be to ask students how these economists were able to measure economic variables, such as GDP one million years ago, when the United States has been collecting this information for less than a cen-tury! This question is a fair question. But students are not likely to be able to provide a ready answer. The answer is that economists have obtained these data with the help of historians and archeologists – a very multidisciplinary approach to answering economic questions. Historians can help us for the last few thousand years with the written word. However, archeologists are likely to be the people to turn to for information that goes back further than that. The information comes from evidence provided in archeological digs, which shed light on the type of implements and tools used by humans and the kinds of goods they consumed. While the margin of error for these data likely gets larger the further back we explore, we can still use these data to ob-tain a decent approximation for real GDP per person at time periods where it wasn’t actually being measured.

USING EYE ON THE U.S. ECONOMY

U.S. Labor Productivity Growth Since 1960

Students will no doubt be struck by the slow down in economic growth that took place in the 1970s. It is important to stress that there is still a lot of debate in the economics profession about what brought about the slowdown. However, there are a number of factors that most economists agree on that contributed to the decline. First, a



reason that is often pointed to is the Arab oil embargo against the United States following the Arab-Israeli War. It is asserted that a qua-drupling in the price of crude from $3 to $12 created a ripple effect throughout the economy, forcing the costs of production for many manufacturing firms to rise. Firms devoted their investment spending to capital equipment that saved energy rather than capital equipment that increased productivity. Second, some observers assert that envi-ronmental protection laws also played a role, because firms invested in capital designed to decrease pollution rather than capital designed to increase productivity. Third, taxes and government regulation ex-panded in the late 1960s and 1970s, which weakened firms’ and work-ers’ incentives to work hard and efficiently. Finally, rapid inflation during this period distorted saving and investment decisions, leading to a decrease in long-term saving and investment. However, tell the students that not all economists agree with all the suggested reasons and the relative importance of the causes remains controversial. Iden-tifying the relative importance of these causes is a crucial exercise though, as it can be used to help construct current and future policy. For example, your students may notice some similarities between the events that led to the productivity slowdown and recent events. 2008 also saw a dramatic increase in the price of oil, and while the price did drop considerably after peaking halfway through the year, that event might still weigh heavily on future business investment deci-sions. In addition, the democratically controlled Senate and President Obama have been more vocal about the need for greater environmen-tal protection, stricter regulations in various areas of the economy, and higher taxes for high income earners. The only similarity to the 1970s that we haven’t seen is the rapid inflation, though given the un-precedented fiscal and monetary policies used recently, that event may also become a possibility in the not-to-distant future. Given these similarities, will we see a similar labor productivity slowdown in the 2010s, or will we actually see a different outcome in spite of similar events?

USING EYE ON YOUR LIFE

How You Influence and Are Influenced by Economic Growth

An excellent way to stimulate discussion concerning new growth the-ory and how self-interested choices can improve not only an individ-ual’s standard of living, but also improve the economic growth of the nation, is to play the Gordon Gekko famous (or infamous) “Greed is Good” speech from the movie Wall Street (which, not by coincidence, came out shortly after new growth theory rose to prominence). This speech proclaims that mankind has grown primarily because of hu-man greediness. Help your students identify that they are likely in your class as a result of their own greed, in particular, their desire to earn greater income, to have more job security, to have a job they en-



joy more, to have greater knowledge, etc. But their greed has driven them to undertake an investment in themselves that just so happens to not only benefit themselves, but also the U.S. economy. In that re-spect, their greed is good for everyone. This movie clip can also pro-voke debate about if greed is always good. Certainly numerous exam-ples from the past few years of greed that encourages an individual to cheat, steal, or manipulate (perhaps examples such as Bernie Madoff, Stanford Financial Group, Enron, questionable mortgage lending or credit card practices, etc) can be pointed to as counterexamples of the statement that greed is good. Greed is good when it causes people to undertake actions that earn (not simply take) greater rewards. Obvi-ously, this is where the preconditions to growth come into play, com-plete with a slippery-slope discussion of how much government regu-lation is necessary to ensure that people’s greed is well directed to-wards productive outcomes.

Another important discussion for your students involves recognizing that economic growth can have an impact on our standard of living that often doesn’t show up immediately in monetary terms, as money is obviously not the only determinant of happiness and the only re-ward that people direct their actions towards. For example, with eco-nomic growth our economy can “afford” a cleaner environment and because we are more productive we don’t have to work as long. We therefore have the opportunity to enjoy more leisure both during our working years and of course during retirement because we are able to retire earlier due to faster earnings growth.

USING EYE ON RICH AND POOR NATIONS

Why Are Some Nations Rich and Others Poor?

Many students are dumbfounded to discover that there are countries that have a GDP that is less than one tenth the size of the U.S. econ-omy but still manage to sport annual real GDP growth gains that ex-ceed those of the United States. Students will often ask why. A good response is to make an analogy to firm size. Students enjoy talking about the stock market. Ask students if they know what is meant by the terms “large cap” and “small cap” when referring to company size. Someone is bound to respond that it refers to market capitaliza-tion. Now ask them why a company that is already billions of dollars in size (market capitalization, sales, or earnings) probably could not post gains in sales of twenty five to thirty percent per year. The re-sponse you are likely to get is that many of these companies have al-ready experienced a large part of their growth. Smaller companies on the other hand are more nimble and are more likely to be able to make larger gains in growth. This logic not only applies to companies but it also applies to countries as well. Many countries like Hong Kong, Taiwan, Korea, and China have a lot of lost ground to make up and are doing so by growing quickly. However, history tells us that



this pace of growth will slow eventually to a pace that is more sustain-able for a larger economy. On a side note for this Eye, make sure to point out that the scale on the vertical axis means that each gap is not the same dollar amount, but a quadrupling of the previous dollar amount. So, while it might first appear that China’s real GDP per per-son has grown to nearly 3/4th of that of the U.S. (since the line goes to approximately 3/4th up the vertical axis), it is actually less than 1/4 th of the U.S. value.


Item 1990 1991

Aggregate hours (billions) 203.4 200.4

Real GDP (billions of 1996 dol-

lars)

6,684 6,669

Item 2000 2001

Aggregate hours (billions) 240.6 238.8

Real GDP (billions of 1998 dol-

lars)

9,191 9,215


ADDITIONAL EXERCISES FOR ASSIGNMENT

Questions Checkpoint 17.2 The Basics of Economic Growth1. Assume that the U.S. real GDP is $13 trillion and grows at a 3

percent annual growth rate over the next several decades. How long would it take the economy to double in size? How long would it take for the economy to double in size if the growth rate is 2 percent? Why can a lower growth rate be considered an eco-nomic waste?

2. Canada’s real GDP was $840 billion in 1998 and $880 billion in 1999. Canada’s population growth rate in 1999 was 0.8 percent. Calculate:

2a. Canada’s economic growth rate in 1999.2b. The growth rate of real GDP per person in Canada in 1999.2c. The approximate number of years it takes for real GDP per per-

son in Canada to double if the 1999 economic growth rate and population growth rate are maintained.

2d. The approximate number of years it takes for real GDP per per-son in Canada to double if the economic growth rate rises to 6 percent a year but the population growth rate remains the same as it was in 1999.

Checkpoint 17.3 Labor Productivity Growth3. The table provides some

data on the U.S. economy in 1990 and 1991.

3a. Calculate the growth rate of real GDP in 1991.

3b. Calculate labor productiv-ity in 1990 and 1991.

3c. Calculate the growth rate of labor productivity in 1991.

4. The table provides some data on the U.S. economy in 2000 and 2001.

4a. Calculate the growth rate of real GDP in 2001.

4b. Calculate labor productiv-ity in 2000 and 2001.

4c. Calculate the growth rate of labor productivity in 2001.

Checkpoint 17.4 Achieving Faster Growth5. List and discuss the three preconditions for economic growth.



Answers Checkpoint 17.2 The Basics of Economic Growth1. Using the Rule of 70, with 3 percent annual growth, real GDP

doubles in size in approximately 70 3 or 23.3 years. It would take real GDP approximately 70 2 or 35 years to double in size if the growth rate is only 2 percent. A lower growth rate is con-sidered an economic waste because it results in irretrievably lost goods and services. The lower growth rate creates a permanent loss in the standard of living.

2a. Canada’s economic growth rate = ($880 billion – $840 billion) $840 billion 100 = 4.8 percent.

2b. Canada’s growth rate of real GDP per person = 4.8 percent – 0.8 percent = 4.0 percent.

2c. Real GDP per person will double in approximately 70 4.0 = 17.5 years.

2d. If the growth rate of real GDP rises to 6 percent and the popula-tion growth rate remains 0.8 percent, then the growth rate of real GDP per person is 6.0 percent – 0.8 percent, which is 5.2 percent. Real GDP per person will double in approximately 70 5.2 = 13.5 years.

Checkpoint 17.3 Labor Productivity Growth3a. Growth rate of real GDP in 1991 = [($6,669 billion – $6,684 bil-

lion) $6,684 billion] 100 = –0.2 percent. The answer shows that the growth rate of real GDP was negative in 1991.

3b. Labor productivity in 1990 = $6,684 billion 203.4 billion hours = $32.86 an hour. Labor productivity in 1991 = $6,669 billion 200.4 billion hours = $33.28 an hour.

3c. The growth rate of labor productivity equals the change in labor productivity divided by the initial level and then multiplied by 100, which equals ($33.28 – $32.86) $32.86 100 = 1.28 per-cent.

4a. Growth rate of real GDP in 2001 = [($9,215 billion – $9,191 bil-lion) $9,191 billion] 100 = 0.3 percent.

4b. Labor productivity in 2000 = $9,191 billion 240.6 billion hours = $38.20 an hour. Labor productivity in 2001 = $9,215 billion 238.8 billion hours = $38.59 an hour.

4c. The growth rate of labor productivity equals the change in labor productivity divided by the initial level and then multiplied by 100, which equals [($38.59 – $38.20) $38.20] 100 = 1.02 per-cent.



Checkpoint 17.4 Achieving Faster Growth5. There are three preconditions for economic growth:

1. Economic freedom. There has to be a rule of law and an effi-cient legal system, which allows contracts to be enforced and protects private property.

2. Property rights. Clearly established and enforced property rights provide people with the incentive to work and save.

3. Markets. Markets enable people to trade, and to save and in-vest. Markets create a basis by which incentives are fostered.


Business

Potential GDP and Economic Growth