ECONOMIC GROWTH* Chapt er. Key Concepts

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1 Chapt er 6 ECONOMIC GROWTH* Key Concepts The Basics of Economic Growth Economic growth is the expansion of production possibilities. The growth rate is the annual percentage change of a variable. The growth rate of real GDP equals Real GDP in current year Re al Re al GDP in past year GDP in past year 100 The standard of living depends on real GDP per person (also called per capita real GDP), which is real GDP divided by the population. The growth rate of real GDP per person can be calculated using the same formula as above. It also approximately equals the growth rate of real GDP minus the population growth rate. Real GDP can grow because the economy is returning to full employment in an expansion phase of the business cycle or because potential GDP is increasing. Economic growth is the expansion of potential GDP. The Rule of 70 is a mathematical relationship which 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 variable. Long-Term Growth Trends Over the past 100 years, growth in real GDP per person in the United States has averaged 2 percent per year. The growth rate varies from one period to the next. It was rapid in the 1960s but slowed between 1973 and 1983, after which it increased but did not reach the level attained in the 1960s. * This chapter is Chapter 23 in Economics. Among Canada, Japan, and the Europe Big 4, the United States has the highest level of real GDP per person. The gaps between U.S. GDP per person and those in Canada and Europe s Big 4 have been almost constant so these nations are not catching up to the U.S. level of real GDP per person. Many poor nations in Central and South America, Eastern Europe, and Africa are not catching up to the U.S. level of real GDP per person. Hong Kong, Korea, Singapore, and Taiwan are generally growing more rapidly than the United States and so their real GDPs per person are catching up. Singapore, indeed, has slightly surpassed the United States. China also is catching up but from a long way behind. How Potential GDP Grows The aggregate production function is the relationship between real GDP and the quantity of labor employed when all other influences on production remain the same. (Figure 6.2, on the next page, illustrates an aggregate production function.) As the quantity of labor employed increases, real GDP increases. Reflecting the law of diminishing returns, each additional hour of labor employed increases real GDP by less than the previous hour. The demand for labor and the supply of labor depend on the real wage rate, the quantity of goods and services an hour of labor earns. (The money wage rate is the number of dollars an hour of labor earns.) The demand for labor is the relationship between the real wage rate and the number of labor hours hired by all the firms in the economy. The number of hours hired by all firms is the quantity of labor demanded. Because of the law of diminishing returns, firms hire additional workers only if the real wage rate falls. The quantity of labor demanded increases when the real wage decreases and hence the demand for

2 94 CHAPTER 6 (23) labor curve, LD in Figure 6.1, has a negative slope. Labor productivity is the quantity of real GDP produced by an hour of labor; it equals real GDP divided by aggregate labor hours. The demand for labor increases and the demand for labor curve shifts rightward when the productivity of labor increases. The supply of labor is the relationship between the quantity of labor supplied and the real wage rate. The number of labor hours that all the households plan to work is the quantity of labor supplied. A higher real wage rate increases the number of people who choose to work and increases the number of hours people choose to work, so a higher real wage rate increases the quantity of labor supplied. The supply of labor curve, LS in Figure 6.1, has a positive slope. In Figure 6.1 the equilibrium real wage rate is $30 per hour and equilibrium employment is 400 billion hours. The equilibrium amount of employment is full employment. The equilibrium quantity of employment, determined in the labor market, together with the production function, determine potential GDP. In Figure 6.1 equilibrium employment is 400 billion hours. In Figure 6.2, which shows an aggregate production function, the 400 billion hours of labor produce potential GDP of $13 trillion. Potential GDP grows when the supply of labor grows or when labor productivity grows. Growth of the Supply of Labor The quantity of labor grows when the average hours per worker grows, when the employment-to-population ratio grows, or when the working-age population grows. Average hours per worker and the employmentto-population ratio cannot persistently grow, so persistent growth in the quantity of labor is the result of population growth which, in turn, increases the working-age population. When the population grows, the supply of labor increases and the supply of labor curve shifts rightward. The equilibrium real wage rate falls. But equilibrium employment increases so there is a movement upward along the aggregate production function. Potential GDP increases. Growth of Labor Productivity Growth in labor productivity means that real GDP per person rises and the standard of living increases. An increase in technology or capital shifts the production function upward and increase labor productivity. When labor productivity increases, the demand for labor increases and the demand for labor curve shifts rightward. The increase in the demand for labor raises the real wage rate. In addition equilibrium employment increases. The increase in employment and the increase in the aggregate production function both increase potential GDP. Real GDP per person grows and the standard of living rises.

3 ECONOMIC GROWTH 95 Why Labor Productivity Grows Firms, markets, property rights, and money create the conditions necessary for growth in labor productivity but their existence does not guarantee that growth will occur. Once the preconditions are in place, then labor productivity grows with growth in: Physical capital the accumulation of capital adds to the nation s productivity and level of output. Human capital human capital, the skills and talents people possess, is a key ingredient for economic growth. Some human capital is acquired through education; some is obtained through doing the same task over and over. New technologies technological advancement is crucial to economic growth. Often to reap the benefit of technological advances, new physical capital is required because the new technology is embodied in the capital. Growth Theories, Evidence, and Policies Three theories of economic growth are classical growth theory, neoclassical growth theory, and new growth theory. The classical growth theory is the view that real GDP growth is temporary and that when real GDP per person rises above subsistence level, a population explosion eventually brings it back to the subsistence level. When real GDP per person is above the subsistence level, the population growth rate rises which increases the supply of labor, thereby driving the real wage rate back to the subsistence level. Contrary to the (key) assumption of classical theory, it turns out that the population growth rate does not soar when real GDP per person increases. The neoclassical growth theory stresses that real GDP per person grows because technological changes increase saving and investment so that the capital stock grows. Growth ends if technological growth stops because of diminishing marginal returns to labor and capital. Technological change is determined by factors such as luck. Technological change leads to new profit opportunities, which increase investment and saving. The capital stock increases and, as capital accumulates, diminishing returns lowers the profit from additional capital. Eventually saving and investment decrease so that no new capital is accumulated. Real GDP per person remains higher after the technological change than before, but unless technology keeps advancing economic growth ceases. One difficulty with the neoclassical model is its prediction that all nations will converge to the same level of per capita income because this prediction is inaccurate. The new growth theory holds that real GDP per person grows because of the choices people make in the pursuit of profit and that growth will persist indefinitely. Four facts about market economies are important: Discoveries result from people s choices, such as whether to look for something new and, if so, how intensively to look. A new discovery brings the discoverer high profits but eventually competitors emerge and the aboveaverage profit is competed away. Discoveries can be used by everyone without reducing their availability to others, so the benefits from a new discovery spread everywhere. Knowledge is not subject to the law of diminishing returns so the incentive to innovate new and better products and production methods never decreases. The new growth theory concludes that economic growth can persist indefinitely because of the capacity for people to continually innovate. This new growth theory conclusion differs dramatically from the Malthusian conclusion of the classical theory that the economy will eventually return to a subsistence wage. Economic research has studied what factors influence economic growth. Region being far from the equator is good for economic growth; being near the equator is bad. Politics civil liberties and the rule of law are good for growth; military coups, revolutions, and wars are bad. Economic system a capitalist economic system is good for economic growth. Market distortions exchange rate distortions, price controls, and black markets are bad for economic growth. Investment increased investment in human and physical capital is good for economic growth. International trade being open to international trade is good for economic growth. Some of the factors influencing a nation s economic growth (such as region) cannot be changed. Both other factors are amenable to change. Policies for increasing

4 96 CHAPTER 6 (23) the economic growth rate are: Stimulate saving tax incentives could be directed at increasing saving. Stimulate research and development inventions can be copied, so government subsidies can lead to more inventions that spread throughout the economy. Encourage international trade free international trade encourages economic growth because free trade extracts all the possible gains from specialization and exchange. Provide international aid to developing nations the aid, however, must be used wisely by the recipient and not wasted or diverted by corruption. Improve the quality of education education creates benefits beyond that enjoyed by the students who receive education, so without government action, too little education is provided. Helpful Hints 1. CLASSICAL VERSUS NEW GROWTH THEORY : Economics is sometimes called the dismal science. This nickname came about because of the classical growth theory. The main conclusion from the classical approach is that, in the long run, workers are bound to earn only a subsistence wage, a truly dismal result! The fact that the classical model of growth was developed right at the beginning of the industrial revolution is ironic. The classical model focuses on population growth and does not allow for continuing technological change and capital growth, two features of the industrial revolution that were to become an increasingly important aspect of our world. It is these omissions that account for the dismal, subsistence-wage conclusion of the classical model. New growth theory examines the factors that lead to technological change. In this theory, economic growth can persist indefinitely because the incentive to accumulate more capital persists indefinitely. Perhaps the nickname for economics should be changed to the happy science! 2. THE IMPORTANCE OF ECONOMIC GROWTH : Although economic growth theory is important to everyone in the world, it is perhaps most important to people living in poverty stricken nations. For these people, economic growth may spell the difference between life and death. An important point about these government policies designed to increase growth is easy to overlook: Except for providing aid to developing nations, none of them involve explicit government intervention designed to spur growth. The policies work because they boost people s incentives to invest in physical capital and human capital and to develop new technologies, which, in turn, lead to increased economic growth. Questions True/False and Explain The Basics of Economic Growth 11. Increases in real GDP always increase real GDP per person. 12. If real GDP grows at an annual rate of 2 percent, then real GDP will double in 50 years. Long-Term Growth Trends 13. Over the past 100 years, real GDP per person in the United States has grown at an average rate of 5 percent per year. 14. Because U.S. real GDP per person is higher than in other countries, over the past 30 years economic growth has been most rapid in the United States. How Potential GDP Grows 15. The demand for labor curve is downward sloping. 16. As more workers are employed, the productivity of the last worker employed increases. 17. The law of diminishing returns states that as more labor is used, total output produced diminishes. 18. A rise in the real wage rate increases the quantity of labor supplied. 19. When actual employment equals equilibrium employment, the amount of real GDP produced is potential GDP. 10. An increase in the demand for labor raises the real wage rate. 11. An increase in the demand for labor increases potential GDP.

5 ECONOMIC GROWTH An increase in labor productivity increases the full employment quantity of labor. Why Labor Productivity Grows 13. Once firms, markets, property rights, and money have been created, labor productivity growth is inevitable. 14. Population growth is the only source of persistent growth in the supply of labor. 15. Discovery of new technologies helps create growth in labor productivity. Growth Theories, Evidence, and Policies 16. An increase in real wages and incomes increase the population growth rate is an assumption made by classical growth theory. 17. In the neoclassical theory of growth, a technological advance can create perpetual economic growth. 18. The neoclassical growth theory stresses the role played by people s incentives for discovering new technology. 19. In the new theory of economic growth, economic growth can continue indefinitely. 20. Market distortions, such as price controls, are bad for economic growth. Multiple Choice The Basics of Economic Growth 11. If the annual average growth rate of real GDP is 3 percent, then the level of real GDP will double in approximately years. a. 100 b. 33 c. 23 d. 10 Long-Term Growth Trends 12. For the last 100 years in the United States, growth in real GDP per person a. has averaged 2 percent per year. b. has accelerated in the last half century because of the technological revolution. c. was never negative for any year. d. has averaged about 8 percent per year. 13. Which of the following best describes the facts? a. Almost all rich and poor nations are catching up to the level of U.S. GDP per person. b. Almost all rich nations are growing fast enough to catch up to the level of U.S. GDP per person, but virtually no poor nation is growing fast enough to catch up. c. Some poor nations are catching up to the level of U.S. GDP per person, but many poor nations are not catching up. d. No nation is growing fast enough to catch up to the level of U.S. GDP per person. How Potential GDP Grows 14. The demand for labor curve is downward sloping because the a. productivity of labor diminishes as more workers are employed. b. supply curve of labor is upward sloping. c. demand curve shifts when capital increases. d. None of the above answers are correct because the demand for labor curve is upward sloping. 15. As the real wage rate increases, the quantity of labor supplied increases a. only because people already working increase the quantity of labor they supply. b. only because the higher wage rate increases labor force participation. c. because people already working increase the quantity of labor they supply and because the higher wage rate increases labor force participation. d. None of the above answers is correct because an increase in the real wage rate decreases the quantity of labor supplied. 16. At potential GDP, a. the labor market is in equilibrium so that the quantity of labor demanded equals the quantity supplied. b. the labor market might or might not be in equilibrium. c. the real wage has adjusted so that it equals the money wage. d. the real wage rate must be rising because otherwise people will not work.

6 98 CHAPTER 6 (23) 17. An increase in population shifts the a. labor demand curve rightward. b. labor demand curve leftward. c. labor supply curve rightward. d. labor supply curve leftward. 18. Increases in population the real wage rate and real GDP per person. a. do not change; increase b. raise; do not change c. lower; decrease d. raise; increase 19. An advance in technology that increases labor productivity shifts the production function and shifts the demand for labor curve. a. upward; rightward b. upward; leftward c. downward; rightward d. downward; leftward 10. An increase in the demand for labor the real wage and the quantity of employment. a. raises; increases b. raises; decreases c. lowers; increases d. lowers; decreases 11. Technological advances that increase labor productivity and shift the aggregate production function higher, the real wage rate and real GDP per person. a. do not change; increase b. raise; do not change c. lower; decrease d. raise; increase Why Labor Productivity Grows 12. A precondition for increasing labor productivity is a. the existence of an aggregate production function. b. growth in the population. c. social institutions that create the proper incentive system. d. diminishing returns. 13. Which of the following does NOT increase labor productivity? a. an increase in capital b. an increase in aggregate hours c. an investment in human capital d. a discovery of new technologies 14. Technological change a. cannot account for labor productivity growth unless it is combined with growth the supply of labor. b. often is embodied in physical capital. c. needs to be combined with population growth to increase real GDP. d. is a potential source of growth in labor productivity but in reality has had only small effects. Growth Theories, Evidence, and Policies 15. An assumption of the classical growth theory is that a. the population growth rate increases when real GDP per person increases. b. saving is more important than investment in determining economic growth. c. capital plays a major role in determining how rapidly the economy grows. d. human capital is the cause of economic growth. 16. A weakness of the classical theory of growth is its a. emphasis on saving and investment. b. assumption that the growth rate of the population increases when income increases. c. reliance on constant growth in technology. d. neglect of the subsistence real wage. 17. In the neoclassical theory of growth, growth in is the result of luck. a. saving b. income c. technology d. population 18. A key assumption of new growth theory is that a. all technological change is the result of luck. b. higher incomes lead to a higher birth rate. c. people s wants will always exceed the economy s ability to satisfy them. d. knowledge is subject to rapidly diminishing returns.

7 ECONOMIC GROWTH Which theory of economic growth concludes that in the long run people have only a subsistence income? a. The classical growth theory b. The neoclassical growth theory c. The new growth theory d. All of the theories 20. Which theory of economic growth concludes that growth can continue indefinitely? a. The classical growth theory b. The neoclassical growth theory c. The new growth theory d. All of the theories 21. It is good for economic growth if a nation a. imposes price controls on investment goods. b. is close to the equator. c. limits international trade. d. is a capitalist nation. 22. To increase its economic growth, a nation s government should enact policies that saving and that international trade. a. encourage; encourage b. encourage; discourage c. discourage; encourage d. discourage; discourage 23. Economic growth can be increased by a. taxing savings. b. limiting international trade. c. using government funds to help finance basic research. d. decreasing the length of time for which a patent is effective. Short Answer Problems 1. a. Real GDP per person in the nation of Slow is $2,000 and is growing at the rate of 1 percent per year. After 1 year, what is real GDP per person? After 2 years? After 10 years? After 30 years? b. This year real GDP per person in Fast is half of that in Slow, $1,000, but is growing at the rate of 3 percent per year. After 1 year, what is real GDP per person? After 2 years? After 10 years? After 30 years? c. Initially the ratio of GDP per person in Fast to GDP per person in Slow is What is the ratio after 1 year? After 30 years? 2. Suppose that new technology shifts the aggregate production function upward and increases labor productivity. Using Figures 6.3 and 6.4, show what happens in both. Does the equilibrium quantity of employment rise or fall? Does real GDP increase or decrease? 3. The preconditions for growth are firms, markets, property rights, and money. What is the relationship between these preconditions and growth in labor productivity?

8 100 CHAPTER 6 (23) 4. Why can t a high level of GDP per person persist in classical growth theory? In particular, what mechanism drives the economy back to the situation in which workers receive only a subsistence wage? 5. What is the driving factor behind economic growth in the neoclassical model of economic growth? Why does economic growth grind to a halt in the neoclassical model? 7. Igor was recently named economic minister. His first assigned task is to predict his nation s longterm growth prospects. Igor notes that his nation is far from the equator. It is currently capitalist but has had several revolutions and military coups in the recent past. It also is controlling its exchange rate in order to limit imports into the nation. Which of these factors would Igor suggest are good for economic growth? Which are harmful? 8. After Igor announces his prediction from the previous question, the nation s president suggests to Igor that Igor s current position will be short-lived unless productivity growth picks up. Igor likes his current job because it involves no night work and very little digging. What government policies to speed up growth might Igor suggest and why? You re the Teacher 1. This is a really great chapter, but you know, there s one thing that puzzles me just a bit. I just don t get the relationship between the labor market/aggregate production function and economic growth. I know these things have to be related, but I just can t see how and it s really bugging me! Help debug your friend by explaining the relationship between the two. 6. Figure 6.5 shows the situation in which the nation s aggregate production function constantly shifts upward. This figure best illustrates which theory of economic growth? Why?

9 ECONOMIC GROWTH 101 True/False Answers Answers The Basics of Economic Growth 11. F If the population growth exceeds growth in real GDP, real GDP per person falls. 12. F The Rule of 70 shows that with a 2 percent annual growth rate, real GDP will double in approximately 35 years. Long-Term Growth Trends 13. F Real GDP growth per person has averaged 2 percent per year, not 5 percent. 14. F Other nations have grown more rapidly and these nations are catching up to, and in some cases surpassing, the level of U.S. real GDP per person. How Potential GDP Grows 15. T The demand for labor curve is downward sloping because the productivity of labor diminishes as more workers are employed. 16. F As more workers are employed, the productivity diminishes. 17. F The law of diminishing returns states that as more labor is used the additional output produced diminishes. 18. T If the real wage rate rises, more workers enter the labor force and workers already in the labor force supply more hours of work. 19. T Equilibrium employment is full employment, which means the economy is at potential GDP. 10. T An increase in the demand for labor raises both the real wage rate and employment. 11. T Because an increase in the demand for labor increases employment, it also increases potential GDP. 12. T An increase in labor productivity increases the demand for labor, thereby raising the real wage rate and increasing the full employment quantity of labor. Why Labor Productivity Grows 13. F Firms, markets, property rights, and money are necessary for economic growth, but they do not guarantee that it will occur. 14. T Increases in the employment-to-population ratio or in average hours per worker increase aggregate hours, but these two factors cannot increase forever. Only population growth can continue indefinitely. 15. T The discovery of new technologies is a key way of creating growth in real GDP per person. Growth Theories, Evidence, and Policies 16. T The data, however, show that increases in real wages and incomes is associated with little change in the population growth rate. 17. F In the neoclassical theory, a technological advance raises real GDP but does not create persist economic growth. 18. F The neoclassical growth theory stresses the role played by saving and investment; the new growth theory emphasizes people s incentives. 19. T Economic growth can persist forever because people perpetually pursue profit. 20. T Market distortions reduce economic growth. Multiple Choice Answers The Basics of Economic Growth 11. c The Rule of 70 shows that the level of real GDP will double in 70 3, or approximately 23 years. Long-Term Growth Trends 12. a Over the last 100 years, growth in real GDP per person in the United States has averaged 2 percent per year. 13. c If a nation grows more rapidly than the United States, eventually that nation s level of GDP per person will catch up to that in the United States. How Potential GDP Grows 14. a Because of diminishing returns, firms increase the quantity of labor they hire only if the wage rate falls. 15. c For both the reasons given in the answer, the supply of labor curve is upward sloping, indicating that an increase in the real wage rate increases the quantity of labor supplied. 16. a When the labor market is in equilibrium the quantity of labor supplied equals the quantity of

10 102 CHAPTER 6 (23) labor demanded the economy is producing its potential GDP. 17. c With more people, the supply of labor increases. 18. c The increase in population increases the supply of labor which lowers the real wage rate and increases the full employment quantity of labor. The increase in full employment raises potential GDP but diminishing returns means that real GDP per person falls. 19. a The increase in labor productivity shifts the demand for labor curve rightward. 10. a The increase in the demand for labor shifts the demand for labor curve rightward. The equilibrium real wage rate rises and equilibrium employment increases. 11. d The increase in labor productivity increases the demand for labor, which raises the real wage rate. The upward shift of the production function raises potential GDP per person. Why Labor Productivity Grows 12. c The incentive system is that created by the existence of firms, markets, property rights, and money. 13. b An increases in aggregate hours might be a result of an increase in labor productivity but it does not cause an increase in labor productivity. 14. b The idea that technological change is embodied in physical capital means that the physical capital reflects and incorporates the new technology. Growth Theories, Evidence, and Policies 15. a This assumption is important because it leads to the (dismal!) conclusion that people are paid only a subsistence wage. 16. b The previous answer pointed out the importance of the assumption that population growth increases when income increases. However, this assumption is a weakness because the data show it to be false: Population growth does not soar when income increases. 17. c Technological growth is the driving force behind economic growth in the neoclassical theory. However, because technological growth depends on chance and luck in this approach, the neoclassical model has no explanation for why technological growth occurs. 18. c The opportunity to earn an above-average profit gives innovators the incentive to develop new technologies. 19. a This long-run conclusion of the classical theory was based on the (faulty!) assumption that the population growth rate rises when income increases. 20. c Only the new growth theory predicts that economic growth continues forever as the natural course of the economy. 21. d Capitalism gives the nation s citizens the incentive to invest in physical capital, human capital, and develop new technologies, all of which lead to increased economic growth. 22. a By encouraging saving, the nation makes it possible for more investment in physical and human capital. By encouraging international trade, the nation can extract all the possible gains from trade. 23. c Private markets allocate too few funds to basic research because an inventor s profit is limited when others copy the invention. Answers to Short Answer Problems 1. a. After 1 year, real GDP per person in Slow is ($2,000.00)(1.01) or $2, After 2 years, real GDP per person in is ($2,000.00)( 101. ) 2 or $2, Similarly, after 10 years real GDP per person is $2, and after 30 years is $2, b. Real GDP per person in Fast after 1 year is $1,030.00; after 2 years is $1,060.90; after 10 years is $1,343.92; after 30 years is $2, c. After 1 year the ratio of real GDP per person in Fast to real GDP per person in Slow is equal to $1,030.00/$2, = After 30 years the ratio is $2,427.26/$2, = By growing more rapidly than Slow, the nation of Fast has been able to close a large part of the gap in the GDP per person. In other words, by growing more rapidly than the (advanced) nation of Slow, the (poorer) nation of Fast is able to catch up to the (higher) level of real GDP in Slow. In fact, after these 30 years, the level of real GDP in Fast will equal that in Slow in less than 6 more years! With Fast growing at 3 percent per year and Slow growing at 1 percent per year, in 36 years the levels of income will be equal.

11 ECONOMIC GROWTH Start with the aggregate production function, illustrated in Figure 6.6. The upward shift is illustrated. A key feature of this change is that the productivity of labor increased, so the change increases the demand for labor. So in Figure 6.7, the demand for labor curve has shifted rightward, from LD 0 to LD 1. As a result, the equilibrium quantity of employment increases, to 300 billion hours, and the equilibrium real wage rate rises, to $30 per hour in the figure. In Figure 6.6, potential GDP changes for two reasons: First, the aggregate production function has shifted upward, so even if employment did not change, potential GDP would increase. But, employment does increase. Thus as Figure 6.6 demonstrates, potential GDP increases from $11 trillion to $14 trillion as the economy moves from point a on aggregate production function PF 0 to point b on aggregate production function PF These preconditions create incentives for productivity growth. But they are not sufficient for growth to occur. To have persistent labor productivity growth, growth in physical capital, growth in human capital, and/or technological advances must occur. Without the preconditions, which create the incentives for growth in these factors, labor productivity will not grow. But simply having the four preconditions in place is no guarantee that growth in physical capital, human capital, or technology will occur. 4. High levels of real GDP per person do not persist in classical growth theory because of the classical growth theory assumption that population growth is directly related to people s real wage or real income. In particular, an increase in productivity raises people s real wage. Real GDP per person increases. But in response to the higher real GDP per person, the classical theory assumes that the population growth rate increases. As a result, the supply of labor increases, which depresses the real wage. As long as the real wage rate is above the subsistence real wage, population growth remains rapid so the real wage ultimately is driven back to its subsistence level. A high level of real GDP per person is only temporary. 5. The factor that creates economic growth in the neoclassical model is technological progress. As long as technology continues to advance, the economy continues to grow. However the neoclassical model had no explanation for the forces that lead to growth in technology. Economic growth eventually stops in the neoclassical model because of diminishing returns. If technological progress stops, then as more capital is accumulated, the return to additional units of capital falls. Faced with the fall in return, investors slow and eventually stop investing in new capital. When they stop investing, economic growth stops. 6. The figure best describes the new growth theory because it shows the aggregate production function persistently shifting upward. Only the new growth

12 104 CHAPTER 6 (23) theory concludes that technological advances will constantly occur so only the new growth theory predicts that economic growth can persist indefinitely. 7. Igor can count on two of the factors listed as helping his nation s growth prospects: The fact that his nation is far from the equator and the fact that it is capitalist in orientation. But these factors will be partially or totally offset by the others. In particular, the point that his nation has had several revolutions and military coups limits its growth prospects because they make investment in physical and human capital less attractive. After all, why should someone invest in physical capital when a revolution might result in the government confiscating it? And why invest in human capital if a coup leads to government controls on salaries? In addition, the exchange rate controls also harm the nation s prospects for economic growth because the exchange rate controls limit the gains from trade. 8. Igor can suggest four policies. First, he can recommend that his nation stimulate saving by using tax incentives. By increasing saving, his country can increase its growth rate of capital per hour. Second, Igor can recommend that the government subsidize research and development. Research and development will spur technological advances. Third, Igor can recommend encouraging international trade by removing the distorting exchange rate controls. Finally, Igor can suggest that his nation undertake policies to improve the quality and increase the quantity of education. Igor might also suggest that the nation avoid military coups and revolutions but this suggestion is not one that the government can easily implement. You re the Teacher 1. You know, I had to think about this subject a bit myself, and then I finally figured out what s going on. The labor market and aggregate production function together give us the amount of potential GDP. Think about this potential GDP as a snapshot that is, this is the amount of potential GDP at a point in time. Now economic growth is like a movie like one snapshot after another. So in order for the snapshot to change from one frame to the next, something in its creation in the labor market or the aggregate production function must change. For example, suppose technological change is constantly advancing In this case the aggregate production function curve is shifting higher from one snapshot to another. And the demand for labor curve also is shifting rightward from one snapshot to another. So when we compare the one snapshot to another, employment and potential GDP are consistently increasing. Our snapshots can be combined to create a movie and that movie is economic growth.

13 ECONOMIC GROWTH 105 Chapter Quiz 11. Over the last 100 years, U.S. economic growth per person has averaged about percent per year. a. 15 b. 10 c. 5 d Over the past two decades, in which of the following nations or regions is real GDP per person converging to that in the United States? a. Africa b. Eastern Europe c. China d. In all of the above real GDP per person has been converging to that in the United States. 13. According to the neoclassical model of growth, when technology advances and then stops, real GDP per person and the growth rate of real GDP per person. a. permanently increases; permanently increases b. permanently increases; does not permanently increase c. does not permanently increase; permanently increases d. does not permanently increase; does not permanently increase 14. Productivity growth can be the result of a. growth in human capital. b. growth in physical capital. c. technological progress. d. All of the above. 15. An increase in labor productivity potential GDP and real GDP per person. a. decreases; decreases b. decreases; increases c. increases; increases d. increases; decreases 16. An increase in the supply of labor employment and potential GDP. a. increases; decreases b. decreases; increases c. increases; increases d. decreases; decreases 17. The slope of the aggregate production function becomes less steep as the quantity of labor increases, which reflects the effects of a. capital accumulation. b. technological progress. c. diminishing returns. d. population growth. 18. Which of the following factors have economists found to be good for a nation s economic growth? a. Being very close to the equator. b. Government controls on prices that lead to extensive black markets. c. Investing significant amounts of resources in human capital. d. Limiting wasteful investment in new physical capital. 19. The new theory of economic growth assumes that a. the supply of labor increases whenever the wage rate exceeds the subsistence level. b. technological change is the result of luck. c. knowledge does not have diminishing returns. d. economic growth causes nations to converge to the same level of real GDP per person. 10. Which theory of economic growth predicts that nations eventually converge to the same level of real GDP per person? a. The classical growth theory. b. The neoclassical growth theory. c. The new theory of economic growth. d. None of the theories makes this prediction. The answers for this Chapter Quiz are on page 253

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