Chapter 10: Long-run Economic Growth: Sources and Policies

Chapter 10: Long-run Economic Growth: Sources and Policies Yulei Luo SEF of HKU February 13, 2012

Learning Objectives 1. Define economic growth, calculate economic growth rates, and describe trends in economic growth. 2. Use the economic growth model to explain why growth rates differ across countries. 3. Discuss fluctuations in productivity growth in the United States. 4. Explain economic catch-up, and discuss why many poor countries have not experienced rapid economic growth. 5. Discuss government policies that foster economic growth.

Economic Growth Over Time and Around the World Real GDP per capita (p. c.) is the best measure of a country s standard of living. Economic growth occurs when real GDP p. c. increases. We consider EG both over time and around the world, and then discuss why different countries/regions have different growth patterns: high SOL initially and continued to grow rapidly (USA, Canada, UK, etc.); high SOL initially but failed to keep pace (Argentina); low SOL initially and still very low today (Some African countries); low SOL initially but become much richer today (Japan, Hong Kong, Korea, Taiwan, Singapore, etc.).

Economic Growth over Time and around the World Economic Growth from 1,000,000 B.C. to the Present 10.1 LEARNING OBJECTIVE Define economic growth, calculate economic growth rates, and describe global trends in economic growth. FIGURE 10-1 Chapter 10: Long-Run Economic Growth: Sources and Policies Average Annual Growth Rates for the World Economy World economic growth was essentially zero in the years before 1300, and it was very slow an average of only 0.2 percent per year before 1800. The Industrial Revolution made possible the sustained increases in real GDP per capita that have allowed some countries to attain high standards of living. Copyright 2010 Pearson Education, Inc. Macroeconomics R. Glenn Hubbard, Anthony Patrick O Brien, 3e. 7of 39

EG from 1,000,000 B.C. to the Present No sustained EG occurred between 1, 000, 000 B.C. and 1300 A.D. It was estimated that real GDP p.c. was the same (about $140 in 2008 dollars) in both years. It was the minimum amount necessary to sustain life. Significant EG did not begin until the industrial revolution. Industrial Revolution (IR): The application of mechanical power to the production of goods, beginning in England around 1750 and spreading to US, FR, GER. It greatly increases labor productivity.

Making the Connection Why Did the Industrial Revolution Begin in England? 10.1 LEARNING OBJECTIVE Define economic growth, calculate economic growth rates, and describe global trends in economic growth. Chapter 10: Long-Run Economic Growth: Sources and Policies The British government s guarantee of property rights set the stage for the Industrial Revolution. Most economists accept the idea that economic growth is not likely to occur unless a country s government provides the necessary type of institutional framework. YOUR TURN: Test your understanding by doing related problem 1.3 at the end of this chapter. Copyright 2010 Pearson Education, Inc. Macroeconomics R. Glenn Hubbard, Anthony Patrick O Brien, 3e. 6of 39

Why did the Industrial Revolution Occur in England? IR was a key turning point in human history: Before it, EG is slow and halting. After it, EG is rapid and sustained. No consensus so far: why did IR occur in England then? Some arguments: Institutions in England differed significantly from those in other countries in ways that greatly stimulated EG. After the Glorious revolution, the British Parliament controlled the gov. and the court system also became independent of the king. The British gov. was able to credibly to commit to upholding private property rights, protecting wealth, and eliminating arbitrary increases in taxes. These changes strengthened entrepreneurs s incentive to make new investments.

Small Differences in Growth Rates Are Important Small differences in growth rates can have a large impact. Compounding: The higher interest rate is applied to a larger amount; the lower interest rate is applied to a small amount. E.g., Invest $100 in a savings account, two interest rates: 1.3% or 2.3%. The compounding process magnifies even small difference in growth rates over long periods of time: E.g., in 1950 real GDP p.c. in Argentina was $6942 (measured in 2000 dollars), while real GDP in France was $5921. Over the next 58 years, the EG rate in France averaged 2.7% per year, while in Arg. it was only 1%. This small difference has a large impact on the SOL in both countries: in 2008, real GDP p.c. in France had risen to $27, 274, while real GDP in Arg, was only $12, 994.

(cont.) Growth rates matter because an economy that grows too slowly fails to raise living standards. We can divide the world s economies into two groups: 1. The high-income countries (the industrial or developed countries); 2. the developing counties. In the 1980s and 1990s, a small group of countries, mostly East Asian countries/regions such as Hong Kong, South Korea, Taiwan, and Singapore, experienced high rates of growth and are sometimes referred to as the newly industrializing countries and regions.

Economic Growth over Time and around the World The Rich Get Richer and... 10.1 LEARNING OBJECTIVE Define economic growth, calculate economic growth rates, and describe global trends in economic growth. Chapter 10: Long-Run Economic Growth: Sources and Policies FIGURE 10-2 GDP per Capita, 2008 GDP per capita is measured in U.S. dollars, corrected for differences across countries in the cost of living. Copyright 2010 Pearson Education, Inc. Macroeconomics R. Glenn Hubbard, Anthony Patrick O Brien, 3e. 10 of 39

What Determines How Fast Economies Grow? Economic growth (EG) model: A model that explains growth rates in real GDP per capita over the long run. Labor productivity (LP): The quantity of goods and services that can be produced by one worker or by one hour of work. Economists believe two key factors determine labor productivity: the quantity of capital per hour worked and the level of technology. Due to the importance of LP, the EG model focuses on the causes of long-run increases in LP. Technological change: Change in the ability of a firm to produce output with a given quantity of inputs (capital and labor).

(cont.) Three main sources of technological change: 1. Better machinery and equipment: Today, continuing improvements in computers, machine tools, electronic generators, and other machines contribute to increases in L.P. 2. Increases in human capital: H.C. is the accumulated knowledge and skills that workers acquire from education and training or from their life experience. As workers increase their H.C. through education and training, their productivity will also increase. 3. Better means of organizing and managing production: L.P. will increase if managers can do a better job of organizing production. E.g., with some effi cient system, fewer workers are needed to produce the same amount of products and then the quantity produced per hour worked will increase.

The Per-Worker Production Function Per-worker production function: The relationship between real GDP, or output, per hour worked and capital per hour worked, holding the level of technology constant. When holding technology constant, equal increases in the amount of capital p.h. worked lead to diminishing increases in output p.h. worked. At very high levels of capital p.h. worked, further increases in capital p.h. will not result in any increase in real GDP p.h. This effect results from the law of diminishing returns: as we add more of one input (capital) and let another inputs unchanged, output increases by smaller additional amounts.

Which is More Important for EG: More Capital or Technological Change? Technological change can help economies avoid diminishing return to capital (DRTC). Some examples of TC include: the replacement of existing capital with more productive capital; reorganizing how production takes place so as to increase output. Because of DRTC, continuing increases in real GDP p.h. can be sustained only if there is technological change.

What Determines How Fast Economies Grow? The Per-Worker Production Function 10.2 LEARNING OBJECTIVE Use the economic growth model to explain why growth rates differ across countries. FIGURE 10-3 Chapter 10: Long-Run Economic Growth: Sources and Policies The Per-Worker Production Function The per-worker production function shows the relationship between capital per hour worked and real GDP per hour worked, holding technology constant. Increases in capital per hour worked increase output per hour worked but at a diminishing rate. For example, an increase in capital per hour worked from $20,000 to $30,000 increases real GDP per hour worked from $200 to $350. An increase in capital per hour worked from $30,000 to $40,000 increases real GDP per hour worked only from $350 to $475. Each additional $10,000 increase in capital per hour worked results in a progressively smaller increase in output per hour worked. Copyright 2010 Pearson Education, Inc. Macroeconomics R. Glenn Hubbard, Anthony Patrick O Brien, 3e. 14 of 39

What Determines How Fast Economies Grow? Which Is More Important for Economic Growth: More Capital or Technological Change? 10.2 LEARNING OBJECTIVE Use the economic growth model to explain why growth rates differ across countries. Chapter 10: Long-Run Economic Growth: Sources and Policies Technological change helps economies avoid diminishing returns to capital. Copyright 2010 Pearson Education, Inc. Macroeconomics R. Glenn Hubbard, Anthony Patrick O Brien, 3e. 15 of 39

What Determines How Fast Economies Grow? Technological Change: The Key to Sustaining Economic Growth 10.2 LEARNING OBJECTIVE Use the economic growth model to explain why growth rates differ across countries. Chapter 10: Long-Run Economic Growth: Sources and Policies FIGURE 10-4 Technological Change Increases Output per Hour Worked Technological change shifts up the production function and allows more output per hour worked with the same amount of capital per hour worked. For example, along Production function 1 with $50,000 in capital per hour worked, the economy can produce $575 in real GDP per hour worked. However, an increase in technology that shifts the economy to Production function 2 makes it possible to produce $675 in real GDP per hour worked with the same level of capital per hour worked. Copyright 2010 Pearson Education, Inc. Macroeconomics R. Glenn Hubbard, Anthony Patrick O Brien, 3e. 16 of 39

Making the Connection What Explains the Economic Failure of the Soviet Union? 10.2 LEARNING OBJECTIVE Use the economic growth model to explain why growth rates differ across countries. Chapter 10: Long-Run Economic Growth: Sources and Policies The fall of the Berlin Wall in 1989 symbolized the failure of Communism. A centrally planned economy, such as the Soviet Union s, could not, over the long run, grow faster than a market economy. The Soviet Union collapsed in 1991, and contemporary Russia now has a more market-oriented system, although the government continues to play a much larger role in the economy than does the government in the United States. YOUR TURN: Test your understanding by doing related problem 2.8 at the end of this chapter. Copyright 2010 Pearson Education, Inc. Macroeconomics R. Glenn Hubbard, Anthony Patrick O Brien, 3e. 17 of 39

Endogenous Growth Theory The Economic Growth model: Technological change (TC) is the key factor in explaining long-run growth in real GDP p.c. It was first developed in the 1950s by Robert Solow. Recently, some economists have become unsatisfied with it because it doesn t explain the factors that determine TC. Endogenous growth theory: A model of long-run economic growth that emphasizes that technological change is influenced by how individuals and firms respond to economic incentives, and so is determined by the working of the market system. Endogenous growth theory proposed by Paul Romer, who argues that the accumulation of knowledge capital is the key determinant of EG.

(cont.) The use of physical capital, such as computer, is: rival because if one firm uses it other firms cannot; excludable because the firm that owns the capital can keep other firms from using it. However, knowledge capital, such as a chemical formula, is non-rival and non-excludable because: one firm s using this knowledge doesn t prevent another firm s using it; once it becomes known, it becomes widely available for other firms to use (unless the gov. gives the firm the legal right to exclusive use of it).

(cont.) Patent: The exclusive right to a product for a period of 20 years from the date the product was invented. Because KC is non-rival and non-excludable, firms can free ride on the R&D of other firms (They benefit from the results of R&D they didn t pay for). Firms are thus unlikely to invest in R&D up to the optimal/effi cient level and there is likely to be an ineffi ciently small amount of R&D, slowing the accumulation of KC and economic growth. However, government policy can help increase the accumulation of KC.

(cont.) Government policy can help increase KC closer to the optimal level in three ways: 1. Protecting intellectual property with patents and copyrights: They can increase the firm s incentive to engage in R&D and then reduce the ineffi ciency caused by KC. 2. Subsidizing R&D: It can increase the quantity of R&D. In US, the gov carries out some research directly (NIH). It can also provide grants to researchers in universities through NSF and other agencies. Finally, it provides tax benefits. 3. Subsidizing education: It can increase the number of workers with technical training. The gov. can subsidize edu by directly providing free education, support for public colleges and univ, or loans.

Joseph Schumpeter and Creative Destruction Schumpeter developed a model of growth in which new products will lead to creative destruction in which older products and firms that produced them are driven out of the market. E.g., DVD player displaced VHS and VCR by better meeting consumer demand for watching films at home. To Schumpeter, the entrepreneur is central to economic growth: They have incentives (profits) for bringing together the factors of production to start new firms and introduce new products. Successful entrepreneurs can use their profits to finance the development of new products and attract more funds from investors.

Economic Growth in the United States The continuing TC led to rapid EG in the US until the 1970s. Actually, the growth rate of the US accelerated over time until then. Productivity in the US grew rapidly from the end of WW II until the mid-1970. Growth then slowed down for 20 years before increasing again after 1995.

Economic Growth in the United States 10.3 LEARNING OBJECTIVE Discuss fluctuations in productivity growth in the United States. Economic Growth in the United States since 1950 Chapter 10: Long-Run Economic Growth: Sources and Policies FIGURE 10-5 Average Annual Growth Rates in Real GDP per Hour Worked in the United States The growth rate in the United States increased from 1800 through the mid- 1970s. Then, for more than 20 years, growth slowed before increasing again in the mid-1990s. Copyright 2010 Pearson Education, Inc. Macroeconomics R. Glenn Hubbard, Anthony Patrick O Brien, 3e. 21 of 39

What Caused the Productivity Slowdown of 1973-1995? Was it a measurement problem? Productivity really didn t slow down during these years. It only appears to have slowed down because of problems in measuring productivity accurately. E.g., The fraction of services in GDP became larger and The fraction of goods in GDP became smaller. It is more diffi cult to measure services in GDP. There may also be a measurement problem in accounting for improvements in the environment and in health and safety. New laws required firms to spend more to reduce pollution, improving workplace safety, and so on.

(cont.) Was it the effect of high oil prices? In 1973, OPEC (an organization that exports oil) increased the price of oil significantly. The higher oil prices increased production costs for many firms in the US (They use oil directly or indirectly). However, the productivity slowdown continued after US firms had fully adjusted to high oil prices. In fact, it continued into the late 1980s and early 1990s when oil prices declined. Was it the declining quality of labor? Deterioration in the US educational system may have contributed to the slowdown. However, it is diffi cult to estimate how much of the slowdown may have been due to this effect. The productivity slowdownn affected all industrial countries: Therefore, there must have common reasons that can explain the slowdown experienced in all leading industrial countries. Hence, the measurement problem become more plausible.

Economic Growth in the United States 10.3 LEARNING OBJECTIVE Discuss fluctuations in productivity growth in the United States. Productivity Growth in the High-Income Economies, 1995-2008 Chapter 10: Long-Run Economic Growth: Sources and Policies FIGURE 10-6 Productivity Growth in the Leading Industrial Economies, 1996 2008 Productivity growth as measured by the average annual growth rate of labor productivity was more rapid in the United States than in the other high-income countries during the years between 1995 and 2008. Copyright 2010 Pearson Education, Inc. Macroeconomics R. Glenn Hubbard, Anthony Patrick O Brien, 3e. 23 of 39

Why has Productivity Growth Been Faster in the U.S. than in Other Countries? 1. The greater flexibility of US labor markets: In most Euro. countries, gov. regulations make it diffi cult to fire workers. Consequently, firms are reluctant to hire workers and then younger workers have diffi culty finding jobs. In contrast, in the US, gov regulations are less restrictive. Workers can find jobs easily and also change jobs more frequently that ensures a better match between workers and jobs and then increases LP. 2. The greater effi ciency of the US financial system: TC is essential to rapid EG. The effi cient FS in the US aids firms to borrow funds to implement new technology.

Why Isn t the Whole World Rich? Catch-up: Sometimes, but Not Always 10.4 LEARNING OBJECTIVE Explain economic catch-up and discuss why many poor countries have not experienced rapid economic growth. Chapter 10: Long-Run Economic Growth: Sources and Policies FIGURE 10-7 The Catch-up Predicted by the Economic Growth Model According to the economic growth model, countries that start with lower levels of real GDP per capita should grow faster (points near the top of the line) than countries that start with higher levels of real GDP per capita (points near the bottom of the line). Copyright 2010 Pearson Education, Inc. Macroeconomics R. Glenn Hubbard, Anthony Patrick O Brien, 3e. 25 of 39

Why Isn t the Whole World Rich? Catch-up: Sometimes, but Not Always 10.4 LEARNING OBJECTIVE Explain economic catch-up and discuss why many poor countries have not experienced rapid economic growth. Catch-up among High-Income Countries FIGURE 10-8 Chapter 10: Long-Run Economic Growth: Sources and Policies There Has Been Catchup among High-income Countries Looking only at countries that currently have high incomes, countries such as Ireland and Japan that had the lowest incomes in 1960 grew the fastest between 1960 and 2008.Countries such as Switzerland and the United States that had the highest incomes in 1960 grew the slowest. Copyright 2010 Pearson Education, Inc. Macroeconomics R. Glenn Hubbard, Anthony Patrick O Brien, 3e. 26 of 39

Why Isn t the Whole World Rich? Catch-up: Sometimes, but Not Always 10.4 LEARNING OBJECTIVE Explain economic catch-up and discuss why many poor countries have not experienced rapid economic growth. Are the Developing Countries Catching Up to the High-income Countries? Chapter 10: Long-Run Economic Growth: Sources and Policies FIGURE 10-9 Most of the World Hasn t Been Catching Up Looking at all countries for which statistics are available does not show the catch-up predicted by the economic growth model. Some countries that had low levels of real GDP per capita in 1960, such as Niger, Madagascar, and the Democratic Republic of the Congo, actually experienced negative economic growth. Other countries that started with low levels of real GDP per capita, such as Malaysia and South Korea, grew rapidly. Some middle-income countries in 1960, such as Venezuela, hardly grew between 1960 and 2008, while others, such as Israel, experienced significant growth. Copyright 2010 Pearson Education, Inc. Macroeconomics R. Glenn Hubbard, Anthony Patrick O Brien, 3e. 27 of 39

Solved Problem 10-4 The Economic Growth Model s Prediction of Catch-up 10.4 LEARNING OBJECTIVE Explain economic catch-up and discuss why many poor countries have not experienced rapid economic growth. COUNTRY REAL GDP PER CAPITA IN 1960 (2000 DOLLARS) ANNUAL GROWTH IN REAL GDP PER CAPITA, 1960 2008 Chapter 10: Long-Run Economic Growth: Sources and Policies Taiwan $1,443 6.01% Tunisia 2,102 3.14 Brazil 2,643 2.37 Algeria 3,843 1.05 Japan 4,509 3.73 Italy 7,167 2.47 Venezuela 7,838 0.82 United Kingdom 10,323 2.14 New Zealand 12,063 1.41 YOUR TURN: For more practice, do related problems 4.4 and 4.5 at the end of this chapter. Copyright 2010 Pearson Education, Inc. Macroeconomics R. Glenn Hubbard, Anthony Patrick O Brien, 3e. 28 of 39

Why don t More Low-Income Countries Experience Rapid Growth? 1. Failure to enforce the rule of law Rule of Law: The ability of a gov. to enforce the laws of the country, particularly with respect to protecting private property and enforcing contracts. 2. Wars and revolutions made it impossible for countries to accumulate enough capital stock or adopt new technologies. And conducting any kind of businesses was very diffi cult. 3. Poor public education and health Many low-income countries have weak public school systems, so many workers are unable to read and write. People who are sick work less and are less productive when they do work. 4. Low rates of saving and investment: The low savings rates in developing countries contribute to a vicious cycle of poverty.

The Benefits of Globalization Foreign direct investment: When corporations build or purchase facilities in foreign countries. Foreign portfolio investment: The purchase by an individual or firm of stock or bonds issued in another country. Globalization: The process of countries becoming more open to foreign trade and investment.

Why Isn t the Whole World Rich? The Benefits of Globalization 10.4 LEARNING OBJECTIVE Explain economic catch-up and discuss why many poor countries have not experienced rapid economic growth. FIGURE 10-10 Globalization and Growth Chapter 10: Long-Run Economic Growth: Sources and Policies Developing countries that were more open to foreign trade and investment grew much faster during the 1990s than developing countries that were less open. Copyright 2010 Pearson Education, Inc. Macroeconomics R. Glenn Hubbard, Anthony Patrick O Brien, 3e. 34 of 39

Growth Policies Even small differences in growth rates compounded over the years can lead to major differences in SOL. Therefore, there is potentially a very high payoff to government policies that increase growth rates: Enhancing property rights and the rule of law increased political stability is a necessary prerequisite to EG. Improving health and education: As people s health improves, they will become more productive. Lucas argued that productivity increases as H.C. increases. Gov. should subsidize education to promote EG. Policies with respect to technology: Subsidizing R&D. Policies with respect to saving and investment Increase the incentives to save and invest.

Key Terms in Chapter 9 Industrial Revolution Labor productivity Technological change Human capital Per-worker production function Economic growth model Endogenous growth theory Catch-up Foreign direct investment (FDI); foreign portfolio investment; globalization