Economic Growth · 2017-12-22 · Economic Growth Slide 19 Rule of 70 FV = PV (1+r)t Where FV = future value in t+1 years of a present value PV at r% rate of interest. Doubling implies

Economic Growth

Xi Wang

UMSL, summer

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Copyright c 2004 by The McGraw-Hill

Companies, Inc. All rights reserved.

Learning Objectives

1. Show how small differences in growth rates

lead to large differences in living standards

2. Explain why GDP per capita is average labor

productivity times the proportion of the

population employed

Use this to discuss the sources of growth

3. Discuss the determinants of average labor

productivity - analyze differences in GDP per

capita across countries

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Learning Objectives…continued

4. Compare and contrast the benefits and costs

of economic growth

5. Discuss and evaluate government policies

that promote growth

6. Understand the trade-offs between economic

growth and environmental quality

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Introduction

Which would you rather be?

An ordinary, middleclass American living today

The richest person in America at the time of George

Washington

For most of civilized human history people

have lived a bare subsistence mostly out of

agriculture. Large cities grew and so did

imperial powers but most of the population

lived at best at subsistence with malnutrition

and disease

UNTIL….

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Introduction

About 300 years ago … a fundamental

change occurred

Technological advances and entrepreneurial

innovations ushered in a new era of sustained (long

run) economic growth, changing every aspect of

how we live…

According to many economists: Long run

economic growth and the ensuing increase in

living standards – why it occurs and how to

achieve it – is by far the most important issue in

Macroeconomics.

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Angus Maddison was a British economist

specializing in quantitative macroeconomic

history, including the measurement and

analysis of economic growth and

development.

www.theworldeconomy.org

http://www.ggdc.net/maddison/oriindex.htm

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How Much Have We Grown?

http://www.theworldeconomy.org/

http://www.ggdc.net/maddison/oriindex.htm

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From the year 1000 to 1820 AD the

advancement in per capita income was a

slow crawl — the world average rose about 50

per cent. Most of the growth went to

accommodate a fourfold increase in

population.

Since 1820, world development has been

much more dynamic. Per capita income rose

more than eightfold, population more than

fivefold.

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Hans Rosling is a Swedish medical doctor,

academic, statistician and public speaker.

BBC video at

https://www.youtube.com/watch?v=jbkSRLYSo

jo

Global GDP growth prospects - Economist

http://www.economist.com/blogs/graphicdet

ail/2015/01/daily-chart

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https://www.youtube.com/watch?v=jbkSRLYSojo

http://www.economist.com/blogs/graphicdetail/2015/01/daily-chart

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Real GDP per Person in Five

Industrialized Countries, 1870 - 2003E

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Real Per Capita GDP 1870 - 2003

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Observations…

The US was already a relatively wealthy

industrialized country in 1870

US real per capita GDP grew 12 times

between 1870 and 2003. In Japan, real per

capita GDP grew 28 times over the same

period 1870 – 2003

Significant part of the growth is post 1950

especially in Japan and post 1979 in China

Caution: Older data are not as reliable and is

not strictly comparable to newer data (how

does a Jet compare with a stagecoach?)

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Observations…continued

Small differences in Growth rates matter

Brazil was richer than Japan in 1870.

However, over the period 1870 – 2003, Japan

had the highest growth rate of 2.6% and

Brazil’s was 1.6%

This 1% differential was enough to make

Japan’s real per capita GDP be more than 3

times as large as Brazil’s in 2003.

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Real Per Capita GDP Growth Rates

1870 – 2003

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Power of Compounding

An Indian Emperor was so excited about the game of chess that he offered the inventor of the game one wish. The inventor replied that he wanted one grain of rice on the first square of the chess board, two grains on the second square, four on the third and so on through the 64th square. The Emperor readily agreed to this simple request.

The 64th square would hold 18 million trillion grains of rice - more than enough to cover the entire surface of the earth. The embarrassed Emperor had the inventor beheaded.

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Why “Small” Differences in Growth

Rates Concept of Compound Interest: N=P(1+r)t

How much will an Investment (N) of $10 in year 1800 @ 4% interest

be worth in year 2005?

In 1801, N = $10.40 = $10 x (1.04)

In 1802, N = $10.40 x (1.04) = $10 x (1.04)2 = $10.82

In 2005, N = $10 x (1.04)205 = $31,033.77

If the starting year is year 1, then the value of N in Year t+1 will

be: $10 x (1+r)t

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Power of Compounding

How much would an initial Investment (N) of

$10 in year 1800 @ 2% compound interest be

worth in year 2005?

In 2005, N = $10 x (1.02)205 = $579.48

@ 4% simple interest ? N = P(1+rt)

In 2005, N = $10 (1+ (205 x 0.04)) = $92.00

@ 4% compound interest? 10(1+ .04)205 =

31,033

@ 6% compound interest? N = $10 x (1.06)205 =

$1,540,644.29

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Why “Small” Differences in Growth

Rates Matter Concept of Compound Interest

The payment of interest is not just on the original deposit but also on all previously accumulated interest

Economic growth rates are similar to compound interest rates.

Government policies that affect the long-term growth rate by a small amount will have a major economic impact.

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Companies, Inc. All rights reserved. Economic Growth Slide 19

Rule of 70

FV = PV (1+r)t

Where FV = future value in t+1 years of a present value PV at r% rate of interest.

Doubling implies FV = 2PV.

So 2 = (1+r)t Taking natural logs on both sides we get: ln2 = t ln(1+r)

Assuming r is small, ln(1+r) by Taylor’s expansion is approximately equal to r and ln2=0.693.

So t is approximately equal to = 69.3/r%

Why 72? Because it has more factors.

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Rule of 70

How long does it take for per capita real GDP

to double itself?

where n = number of years it takes for the

variable to double itself. Some economists

use 69, 69.3 or 70; works for small and

moderate growth rates that are positive.

US took 72/1.9 = 38 years to double per capita

real GDP.

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RateGrowth Annual

72 n

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Determinants of Economic Growth: The

Crucial Role of Average Labor Productivity

We know that economic growth rates are

measured by annual percentage change in

Per capital Real GDP.

Y=Real GDP; N=employed; POP = Total population

Per capita real GDP is (Y/POP) is the product of average labor

productivity (Y/N) and share of population employed (N/POP);

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POP

Nx

N

Y

POP

Y

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Understanding Growth

GDP per capita increases when

Output per worker (Y / N) increases OR

The share of the population employed (N / POP) increases

Between 1960 and 2007,

GDP per capita increased 172%

Output per worker increased 110%

The share of the population employed increased from 36% to 48%

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Real GDP per Person and Average

Labor Productivity in the U.S., 1960 - 2006E

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Share of the U.S. Population

Employed, 1960 - 2006E

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Understanding Growth

Share of population employed (N/POP) rose

from 36% to 48% of the entire population.

Why?

increase in labor force participation of women

the share of working age population (age 16 – 65) in total population

rose (coming of age of baby boomers and immigration).

Rise in N/POP is expected to slow down. Why?

female LFPR has stabilized

baby boomers will enter retirement around 2010

So hopes are on average labor productivity

(Y/N)

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Understanding Growth: The Crucial

Role of Average Labor ProductivityE

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In the long run,

increases in output per person

arise primarily from

increases in average labor productivity

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The Determinants of Average

Labor Productivity

High labor productivity is not determined only by the willingness of the population to work hard.

The determinants of Average Labor Productivity are: 1. Human Capital

2. Physical Capital

3. Land and Other Natural Resources

4. Technology

5. Entrepreneurship and Management

6. Political and Legal Environment

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1. Human Capital and

Average Labor

Productivity Human Capital

The talents, education, training, and skills of workers raise productivity

Human capital is a the result of a combination

of factors such as education, training,

experience, intelligence, trustworthiness,

initiative, etc.

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Human Capital

Jack and Jill wrap chocolate candies on the assembly line. Jack

(a novice) can wrap 100/hour while Jill (who has received on-the-job-training) can wrap 300/hr. If they each work 40 hours a

week, Jack’s weekly average labor productivity (ALP) is 4000

candies and Jill’s is 12,000. ALP for this economy is 8000 candies

per week or 200 candies per hour.

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Human Capital: Story of Germany

and Japan Germany and Japan were devastated during WWII.

Yet in 30 years both had rebuilt and become worldwide economic leaders. How?

Foreign (mostly US) aid helped. But most economists agree that high levels of human capital played an important role in both countries.

Germany – well educated population especially scientists and engineers; extensive apprentice system providing on-the-job-training; influx of trained labor from East Germany and Russia.

Creation of technologically sophisticated and highly productive manufacturing sector – highest standards of living in Europe by 1960

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Human Capital: Story of Germany

and Japan…continued Japan was practically destroyed after WWII.

The occupying US forces restructured the Japanese school system and encouraged all citizens to obtain a good education.

Even more than Germany, Japan emphasized on-the-job-training. With lifetime employment, employers invested heavily in worker training.

By 1980, Japanese manufactured goods were among the best in the world and its labor force, among the most skilled.

East Germany did not have the same experience although levels of human capital were comparable to West Germany.

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2. Physical Capital and

Average Labor

Productivity Physical Capital

Worker productivity depends not only on their skills (human capital)

but on the tools/machines (physical capital) they have to work with.

An excellent surgeon needs his equipment to perform surgery

The average US worker today is backed by

about $130,000 worth of physical capital – far

more than 100 years ago and more than most

other nations in the world.

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Diminishing returns Example: Jack

and Jill with Machines

Candy Co buys an electric candy-wrapping machine to be operated by one worker

Any worker (trained or untrained) using the machine can wrap 500 candies/hr

Assume for simplicity that the machine can be assigned to one worker only. Who should use the machine - Jack or Jill?

Why?

Jack’s output 500/hr; Jill’s is 300/hr; total is 800/hr; average is 400/hr – doubled with introduction of machine

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Productivity with

Automation What would happen if a second machine is

introduced?

Each worker can now have a machine. Total output is 1000/hr;

average productivity is 500/hr.

What if a third machine is introduced?

Marginal product of the third machine is zero because there are only

two workers.

Can you see Diminishing Marginal Productivity?

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Two Observations on Physical Capital

and Labor Productivity

Ceteris Paribus, a greater quantity of physical capital per worker raises average/marginal labor productivity We say, labor and capital are complements in production

However, physical capital is subject to diminishing returns If labor and other inputs are held constant, then the greater the

amount of physical capital already in use, the less an additional unit of capital will add to productivity.

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Diminishing Returns

Diminishing returns to capital occurs if an addition

of capital with other inputs held constant

increases output by less than the previous

increment of capital

Assumption: all inputs except capital are held constant

Result: output increases at a decreasing rate

When a firm has many machines, the most

productive uses have already been filled

The increment in capital will necessarily be assigned to a

less productive use than the previous increment

Principle of Increasing Opportunity Cost – Low Hanging

Fruit Principle

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Diminishing Returns - GraphicallyK

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Does more capital mean

more productivity?

Is there any empirical

evidence that greater

amounts of capital per capita

raises labor productivity?

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Average Labor Productivity and

Capital per Worker in 15 Countries,

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Strong +ve rel. for poorer nations;

sometimes -ve rel. for the richer nations

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3. Natural Resources: Determinant

of Average Labor Productivity Land and Other Natural Resources

Ceteris Paribus, an abundance of valuable natural resources (fertile

land, rich mineral resources, etc) increases the productivity of workers

and hence per capita real GDP.

Examples – Middle east countries and oil deposits.

But “other things” are not equal. In the

modern world, natural resources is not a very

important factor in determining labor

productivity

Nigeria is poor although it has significant oil deposits

and South Korea is rich although it is poor in natural

resources.

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Natural Resources and Malthus

Historically land was important. In the 19th C countries that were rich typically had abundant supply of rich farmland and mineral deposits – Canada, US, Australia and Argentina.

English economist Thomas Malthus in his 1798 book, “An Essay on the Principle of Population”, predicted that in the long run a great majority of people were destined to live on the edge of starvation.

The MALTHUSIAN argument: Land is finite. Rising world population will reduce land per capita and hence labor productivity. Physical capital and technology improvements cannot raise productivity fast enough. Only starvation will raise death rates high enough to prevent rapid population growth from outstripping productivity growth.

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Was Malthus Right?

In the past - maybe.

Many historians believe that Malthus’ prediction of falling and stagnant productivity was valid for much of human history – until as recently as 1820.

Population pressure was responsible for stagnant productivity growth until the 18th C. Since then, especially 19th C and beyond, other changes - advances in technology; increases in human and physical capital, and, opening up of enormous amounts of cultivable land in the New World have prevented population growth from outstripping productivity growth.

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4. Technology: Determinant of

Average Labor Productivity Today, most economists would agree that

technological advancement is the single most

important source of productivity improvement.

A new technology will expand the productivity in other sectors -

introduction of railroad increased productivity of all its clients as well.

Refrigerated transportation increased productivity of farmers by

opening up national and international markets.

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4. Technology: Determinant of

Average Labor Productivity US labor productivity grew 2.8% from 1947 –

1973

Slowed to 1.4% from 1973 – 1995

Resurgence to 3% since 1995

Growth since 1995 is largely attributed to

information and communications technologies

making workers more productive

Growth seen in industries that produce these technologies and in

industries that use them

Slower growth in sectors that do not use much information and

communications technologies

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1973-95 Slow Productivity Mystery

The slow growth from 1973-95 still remains a mystery.

The first micro-processor was developed in 1971 but it took 25 years or more for that revolution to become standard equipment in the business world – fax machines, desktop and laptop computers, cell phones, email, etc.

So why didn’t information technology raise productivity earlier?

Economic development does not automatically follow from breakthroughs in basic science. It takes time for new inventions to become commercially viable.

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1973-95 Slow Productivity Mystery

A 100 years ago, another powerful technology

– electric power – had spread through the

economy with little impact on productivity.

It was only when the multistoried tightly

packed factory layout was transformed to a

single-storied one that the full impact of the

new technology found its expression in higher

productivity – the famous assembly line.

New technology does not yield benefits if it is

used in old ways.

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Wal-Mart Effect – New Way of Doing

Business After 20 years of being sluggish, rate of growth

of productivity in the US started to rise again.

Was it because of Internet Technology?

Research shows the main increase came from retailing – stores were selling more merchandise per worker.

Wal-Mart had, some time ago, implemented the use of new technology like – using computer software to track inventories, use of bar code scanners, establishing direct electronic link with suppliers. Then, other companies followed.

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5. Entrepreneurship, Management

and Productivity The productivity of workers depends on the people who

decide what to produce and how to produce it – the entrepreneurs

Henry Ford and mass production

Bill Gates and standardized graphical user interface operating system

Larry Page and Sergey Brin and Google's search

Steve Jobs, Steve Wozniak, Ronald Wayne and Apple

Factors influencing entrepreneurship

Taxation, Regulation, Social Customs

Management:

Influences productivity by implementing more efficient methods of production.

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Entrepreneurship and Medieval China

Sung period (960 – 1270 AD) was technically sophisticated.

Inventions included

Paper, Gunpowder, Water wheels, Compass(?)

Economic stagnation followed

Social system limited entrepreneurship

Emperor retained property rights to business

Seizure possible without notice

Scientific advances alone do not ensure technical change and

growth

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6. Role of Government in Determining

Labor Productivity

The Role of Government in Fostering

Productivity

Establish well-defined property rights

Who owns what and how those things can be used

Reliable recourse through courts

Maintain political stability

Promote free and open exchange of ideas

Help in building infrastructure

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Communism and Economic Growth

▪ Why did communism fail?

▪ Because of its poor economic record.

▪ The Soviet Union had enough Human capital; Physical

capital; Natural resources and Technology.

▪ Yet, output per person in the Soviet Union at the time

of its decline in 1991 was probably less than one-

seventh the U.S. rate

What communism did not offer: Private property rights;

Free markets; Modern legal framework.

No incentives for enterprise

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The Costs of Economic Growth

What is the cost of Economic Growth?

It is the cost of creating new capital.

Implies giving up current consumption; save more.

Reduced leisure time, worker’s safety, and health

The cost of R & D

The cost of education and training (human capital)

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Promoting Economic

Growth Government support of education and training

programs

US public education support extend from kindergarten through to institutions of higher learning

Head Start program for pre-school children

Job training and retraining programs

Government pays because education has externalities

A democracy works better with educated voters

Progressive taxes capture some of the higher income

Increases the chances of technical innovation

Poor families may not be able to pay

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Govt. Promoting Eco

Growth Policies that promote saving and investment –

Individual Retirement Account (IRA),

Investment tax credit

Policies that provide and maintain basic

infrastructure - the public capital that

promotes private economic activities

Policies that support research and

development - National Science Foundation;

the Global Positioning System (GPS) was

developed originally for the military

The legal and political framework

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Promoting Economic Growth in

Less developed Countries

Prescription for more human and physical capital

is broadly correct

Appropriate technology and education

Most countries need institutions to support growth

Corruption creates uncertainty about property rights

and drains financial resources out of the country

Regulation discourages entrepreneurship

Taxes discourage risk-taking

Markets do not function efficiently

Lack of political stability discourages foreign investment

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Are There Limits to

Growth? Eco

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We live in a finite world with finite resources - does that

limit economic growth?

Can growth be sustained?

Depletion of some natural resources

Environmental damage and global warming

Limits to growth, assumes economic growth will take the

form of what we have now.

Limits to growth, overlooks that growth expands society’s

capacity to safeguard the environment.

Limits to growth, underestimates the power of markets to

deal with scarcity

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Are There Limits to

Growth?

Why is the air quality so poor in Mexico City?

Middle income economies are the worst affected by the costs of growth - they are well placed to grow rapidly but not rich enough to afford to be “clean”

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The Relationship between Air

Pollution and Real GDP per PersonE

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Real GDP per person

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Companies, Inc. All rights reserved. Krugman Macroeconomics 2ed Slide 59

Stories of Growth - Brazil

Greater natural resource and physical capital, improved

technologies with greater R&D, improved economic

policies – enabled Brazil to achieve significant economic

growth in recent times.

Exploited a natural resource – tropical savanna land called

cerrado

Technology – adding lime and phosphorous made the land

productive; developed cattle breeds and soybeans suited

to the land and climate; now working on wheat

Economic reform (encouraging exports and foreign capital

imports)

Infrastructure – still a problem.

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Companies, Inc. All rights reserved. Slide 60

Stories of Growth – East Asian

Miracle South Korea’s economic growth is unprecedented in

history – beginning in early 1960s, the economy grew at

7% for more than 30 years.

Part of a broader phenomenon called East Asian Miracle –

South Korea, Taiwan, Hong Kong, Singapore and now

China. Since 1975 the whole region has had an economic

growth rate of 6% - 3 times America’s historical average.

HOW? Very high savings rates, excellent basic education,

and substantial technological progress.

Why now? Why not in the past? Taken advantage of the

already developed technologies of the West and Japan –

adopted them and sometimes improved upon them.

Krugman Macroeconomics 2ed

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Stories of Growth – Latin

America’s Disappointment In 1900 per capita real GDP in Argentina, Uruguay and

Southern Brazil were comparable to the then economically

advanced countries. Since 1920, growth has been

disappointing.

Why? Savings and investment rates have been low partly

due to irresponsible govt. policies that led to high inflation

and bank failures and eroded savings; low importance on

education; political instability.

In the 1980s many economists were of the opinion that

Latin American nations were suffering from excessive govt.

intervention. They suggested opening the economies to

imports, selling off inefficient govt. owned enterprises and

generally freeing up individual initiative. So far only Chile

has responded well to these reforms.Krugman Macroeconomics 2ed

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Stories of Growth – Africa’s

Troubles Africa south of the Sahara - home to 780 million people is

intensely poor.

Why?

Years of political instability; war and general anarchy has

made productive investment impossible.

Property rights are not well defined; coupled with

government corruption there is no incentive to own and

improve private property.

Jeffery Sachs of Columbia University thinks Africa is

politically unstable because it is poor. And it is poor

because of unfavorable geographic conditions –

landlocked, hot, infested with tropical diseases and poor

soil. Krugman Macroeconomics 2ed

Slide 63

Growth projections 2015

Krugman Macroeconomics 2ed

End of Chapter

summary

Documents

Economic Growth · 2017-12-22 · Economic Growth Slide 19 Rule of 70 FV = PV (1+r)t Where FV = future value in t+1 years of a present value PV at r% rate of interest. Doubling implies