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Chapter 6

ECONOMIC GROWTH

Define and calculate the growth rate and explain

the implications of sustained growth in economic

activity

Briefly describe the economic growth trends in the

United States and other countries

Explain what makes potential GDP grow

Explain the sources of labor productivity growth

In this chapter-

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World Economic Growth

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Why is Economic Growth Important?

• Measured as growth in real GDP per person (per

capita) - real income per capita.

– Real GDP per capita = 𝑅𝑒𝑎𝑙 𝐺𝐷𝑃

𝑃𝑜𝑝𝑢𝑙𝑎𝑡𝑖𝑜𝑛

• Growth means rising living standard, a higher

quality of life

• Clearly, not a perfect measure.

– want to consider items such as education, environment,

good health, leisure time

– distribution of income

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High Quality of Life in Wealthy Countries Goes Beyond GDP

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Growth Rate

• Growth rate is a percent change:

𝑅𝑒𝑎𝑙 𝐺𝐷𝑃 𝑐𝑢𝑟𝑟𝑒𝑛𝑡 𝑦𝑒𝑎𝑟 − 𝑟𝑒𝑎𝑙 𝐺𝐷𝑃 𝑝𝑟𝑒𝑣𝑖𝑜𝑢𝑠 𝑦𝑒𝑎𝑟

𝑅𝑒𝑎𝑙 𝐺𝐷𝑃 𝑝𝑟𝑒𝑣𝑖𝑜𝑢𝑠 𝑦𝑒𝑎𝑟 𝑥100

For 2016: 51,549 −51,110

51,110 𝑥100 = 0.85%

• Small differences in GDP growth rate matter a lot

over time

• The rule of 70 – if a variable is growing by X percent per year it will double in

approximately 70 / X years

– 70/2 = 35 years - 2% growth per year doubles in 35 years

– 70/4 = 17.5 years - 4% growth per year doubles in 17.5years 6

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Importance of Economic Growth

• US real GDP per capita is currently $52,000

• Is been growing at 1.2% annual growth since

2009. At this rate, per capita real GDP will grow

to $52,000(1.012)20 = $66,010 in 20 years

• At 2% annual growth, this will grow to

$52,000(1.02)20 =$77,270 in 20 years

• Growth rate matters!

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Growth Applies to Investment Returns?

Suppose you have $50,000 to invest

• At 2% annual growth in a savings account this

will grow to $50,000(1.02)20 =$74,300 in 20

years

• and $90,300 at 4%.

• At 7%, in the stock market, $50,000(1.07)20

=$193,480 in 20 years

• Growth rate matters!

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The Basics of Economic Growth

Economic Growth Versus Business Cycle Expansion

• Real GDP can increase for two distinct reasons:

1. The economy might be returning to full employment in an

expansion phase of the business cycle.

2. Potential GDP might be increasing.

• The expansion of potential GDP is economic

growth.

• The return to full employment in an expansion

phase of the business cycle isn’t economic growth.

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The Business Cycle

peak

trough

+3%

+4%

-2%

Long-run economic growth is in this example is 3%.

In the expansion phase of the cycle, the growth rate is > the trend.

Long-Term Growth Trends

From 1914 to 2014, growth in real GDP per person

in the United States averaged 2 percent a year.

• Real GDP per person fell a lot during the Great

Depression and rose rapidly during World War II.

• Growth was rapid during the 1960s.

• Growth slowed during the 1970s and sped up

again in the 1980s and1990s.

Figure on the next slide illustrates this.

Long-Term Growth Trends

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Real GDP Growth in the

World Economy

Figure shows the growth

in the rich countries.

Japan grew rapidly in the

1960s, slower in the

1980s, and stagnated

during the 1990s.

Growth in Europe Big 4,

Canada, and the United

States has been similar.

Long-Term Growth Trends

Figure shows the growth

of real GDP per person in

a group of poor countries.

The gaps between real

GDP per person in the

United States and in these

countries have widened.

Economic Growth Trends

Potential GDP

What Factors Determine Potential GDP?

• Potential GDP is the quantity of real GDP

produced when the quantity of labor employed

is the full-employment quantity.

• To determine potential GDP we use a model

with two components:

• An aggregate production function

• An aggregate labor market

• Potential GDP is supply driven.

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Aggregate Production

Function

The aggregate

production function tells

us how real GDP changes

as the quantity of labor

changes when all other

influences on production

remain the same.

An increase in the quantity

of labor increases real

GDP. Labor is measured

as billions of hours worked

per year.

What Determines Potential GDP

What Determines Potential GDP

The Labor Market

• The demand for labor shows the quantity of labor

demanded and the real wage rate.

• The real wage rate is the money wage rate divided by

the price level. It’s the purchasing power of the money

wage.

• The supply of labor shows the quantity of labor

supplied and the real wage rate.

• The labor market is in equilibrium at the real wage rate

at which the quantity of labor demanded equals the

quantity of labor supplied.

Figure illustrates labor

market equilibrium.

Labor market equilibrium

occurs at a real wage rate of

$35 an hour and 200 billion

hours employed.

At a real wage rate above

$35 an hour, there is a

surplus of labor and the real

wage rate falls.

What Determines Potential GDP

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At a real wage rate

below $35 an hour,

there is a shortage of

labor and the real

wage rate rises.

At the labor market

equilibrium, the

economy is at full

employment.

What Determines Potential GDP

Potential GDP

The quantity of real GDP

produced when the

economy is at full

employment is potential

GDP.

In this example, the

economy is at full-

employment with 200

billion hours of labor

employed and potential

GDP is $13 trillion.

What Determines

Potential GDP

How Potential GDP Grows

Two forces drive growth in potential

real GDP:

Growth in the supply of labor

Growth in labor productivity

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How Potential GDP Grows

Growth in the Supply of Labor (total hours

worked)

The total number of hours worked by all the

people employed change as a result of changes

in:

1. Average hours per worker

2. Employment-to-population ratio

3. Population growth

(1) (2) (3)

𝑻𝒐𝒕𝒂𝒍 𝑯𝒐𝒖𝒓𝒔 =𝑻𝒐𝒕𝒂𝒍 𝑯𝒐𝒖𝒓𝒔

𝑻𝒐𝒕𝒂𝒍 𝑬𝒎𝒑𝒍𝒐𝒚𝒎𝒆𝒏𝒕𝒙

𝑻𝒐𝒕𝒂𝒍 𝑬𝒎𝒑𝒍𝒐𝒚𝒎𝒆𝒏𝒕

𝑷𝒐𝒑𝒖𝒍𝒂𝒕𝒊𝒐𝒏𝒙 𝑷𝒐𝒑𝒖𝒍𝒂𝒕𝒊𝒐𝒏

How Potential GDP Grows

The Effects of Population Growth

• An increase in population increases the supply of

labor.

• With no change in the demand for labor, the

equilibrium real wage rate falls and the

aggregate hours increase.

• The increase in the aggregate hours increases

potential GDP.

The labor supply curve

shifts rightward.

The real wage rate falls.

Aggregate hours

increase.

Effect of Population Growth

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Now we go to the

production function.

The increase in aggregate

hours increases potential

GDP.

Because of the diminishing

returns, the increased

population …

increases real GDP, …

but decreases real GDP per

hour of labor - (16/300 < 13/200)

Effect of Population Growth

How Potential GDP Grows

Growth of Labor Productivity

Population growth increases aggregate hours and

real GDP, but to increase real GDP per person,

labor must become more productive.

Labor productivity is the quantity of real GDP produced

by an hour of labor (16/300 in our example)

If labor becomes more productive, firms are willing to pay

more for a given number of hours so the demand for labor

increases.

Figure shows the effect of

an increase in labor

productivity.

The increase in labor

productivity shifts the

production function

upward.

How Potential GDP Grows

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In the labor market:

An increase in labor

productivity increases the

demand for labor.

With no change in the

supply of labor, the real

wage rate rises …

and aggregate hours

increase.

Growth in Labor Productivity

And with the increase in

aggregate hours, potential

GDP increases.

How Potential GDP Grows

Why Labor Productivity Grows

The growth of labor productivity depends on:

Growth in Physical Capital

Growth in Human Capital

Technological advances

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Why Labor Productivity Grows

Physical Capital Growth

Investment in new capital (more plant and equipment)

increases capital per worker and increases labor

productivity.

Human Capital Growth

Human capital acquired through education, on-the-job

training, and learning-by-doing is the most fundamental

source of labor productivity growth.

Technological Advances

Technological change - the discovery and the application

of new technologies and new goods – is a major driver

increasing labor productivity.

Congressional Budget Office Projection

Growth in Potential GDP – June 2017

Potential GDP 4.0 3.2 3.4 3.3 2.4 1.4 3.2 1.7 1.9 1.8

Potential Labor Force 1.6 2.5 1.7 1.2 1.0 0.5 1.4 0.5 0.5 0.5

Potential Labor Force Productivitya 2.4 0.6 1.7 2.0 1.4 0.9 1.7 1.2 1.4 1.3

Total,

2017–

2027

Projected Average

Annual GrowthAverage Annual Growth

Overall Economy

1950–

1973

1974–

1981

1982–

1990

1991–

2001

2002–

2007

2008–

2016

Total,

1950–

2016

2017–

2020

2021–

2027

SKIP Growth Theories

three growth theories: Classical growth theory,

Neoclassical growth theory, New growth theory