Long-Run Economic Growth

1
Economic Growth

• Long-Run Economic Growth
• and
• Rising Living Standards

2
Economic Growth

• Long-run economic growth
• Increase in real GDP per capita over time
• Increase in the standard of living
• Growth rates and the rule of 70
• Business cycle
• Fluctuations about the long-run growth trend
• Recessions alternate with expansions.

3
Long-Run Economic Growth

• What determines the potential output?
• Labor productivity or Productivity
• Amount of output one average worker can
  produce in an hour
• Average hours of labor
• Number of hours one average worker spends at
  the job
• Labor force participation rate (LFPR)
• Fraction of population that wants to work
• Size of population

4
What Determines the Potential Output?

• Breaking down the total output

5
What Determines the Potential Output?

• Review of some linear algebra
• If Z X Y, then ? Z ?X ?Y
• If Z X / Y, then ? Z ?X - ?Y
• Applying this rule to the equation of total
  output

6
Long-Run Economic Growth

• What matters for a rising standard of living is
  real GDP per capita (i.e. per person)
• Since
• - Total real output Productivity x
  Average Hours x LFPR x Population
• Then
• - Real output per capita Total output
  Population
• Real output per capita Productivity x
  Average Hours x LFPR
• In terms of percentage growth rates

7
Long-Run Economic Growth

• A tendency in most developed countries is that
  average hours of labor are slowly decreasing
• So our last simplification is to ignore
  changes in average hours in the equation
• ? Output per person ? productivity ?
  LFPR

8
Growth in LFPR

• Recall that

9
Growth in LFPR

• Currently, U.S. Bureau of Labor Statistics
  predicts the employment growth rate to be 1 per
  year until 2010, about the same as the growth
  rate of population
• If so, the ? LFPR ? Labor force - ?
  Population 0
• Is there anything we can do to make the labor
  force grow faster than population, and thus
  increase the rate of economic growth?
• Yes
• Increase labor supply
• Increase labor demand

10
Labor Market
11
An Increase in Labor Supply
12
An Increase in Labor Demand
13
The U.S. Labor Market Over A Century
14
How To Increase Employment

• Supply side
• Cut income tax
• Paying 40 of ones income as taxes (federal,
  state, and local) discourages work effort in the
  United States.
• Tax cut would provide incentives to people to
  seek jobs
• Labor supply curve shifts rightward
• Changes in government transfer programs
• Reduce social benefits

15
How To Increase Employment

• Demand side
• Government policies that help increase skills of
  the workforce or that subsidize employment
• government-sponsored training programs
• aid to college students
• employment subsidies to firms

16
Growth in Productivity

• Recently, virtually all growth in the average
  standard of living can be attributed to growth in
  productivity
• The sources for the growth in productivity
• Capital stock
• Human capital
• Technological development
• Entrepreneurship

17
Figure 4 Capital Accumulation and Labor
Productivity
18
Growth in the Capital per Worker

• One key to productivity growth is growth in
  nations capital stock
• With more capital, a given number of workers can
  produce more output than before
• Growth in capital stock will increase
  productivity as long as it increases amount of
  capital per worker

19
Investment and the Capital Stock

• A stock variable measures a quantity at a moment
  in time.
• Capital stock is a measure of total plant and
  equipment in economy at any moment
• A flow variable measures a process that takes
  place over a period of time.
• Investment is a flow variable
• Depreciation is decrease in the value of assets
• As long as investment is greater than
  depreciation, total stock of capital will rise.
• The greater the flow of investment, the faster
  will be the rise in capital stock.

20
Saving and Investment

• Private saving
• Public saving
• Total saving Private saving Public saving
• In a closed economy,

21
The Loanable Funds Market

• Where households make their saving available to
  those who need additional funds
• Supply of loanable funds household saving
• Demand of loanable funds businesses and
  government

22
The Loanable Funds Market

• Businesses demand for loanable funds is equal to
  their planned investment spending (Ip)
• Funds obtained are borrowed, and firms pay
  interest on their loans
• Governments demand for loanable funds
• Budget deficit (G T)
• Excess of government purchases over net taxes
• Governments supply for loanable funds
• Budget surplus (T G)
• Excess of net taxes over government purchases

23
Supply of Household Loanable Funds
24
Business Demand for Loanable Funds
25
The Demand for Funds
26
Loanable Funds Market Equilibrium
27
Targeting Businesses Demand Side

• Reducing business taxes
• Corporate profits tax
• A cut in tax on profits earned by corporations
• Investment tax credit
• A cut in taxes for firms that invest in certain
  favored types of capital
• Reducing business taxes or providing specific
  investment incentives can shift the investment
  curve (the demand curve in the loanable funds
  market) rightward

28
An Increase In Investment Spending
29
Targeting Households Supply Side

• If households decide to save more of their
  incomes at any given interest rate
• Supply of loanable funds curve will shift
  rightward
• What might induce households to increase their
  saving?
• Greater uncertainty about economic future
• Increase in life expectancy
• Anticipation of an earlier retirement
• Change in tastes toward big-ticket items
• Change in attitude about saving
• Any of these changesif they occurred in many
  households simultaneouslywould shift saving
  curve to the right
• What can government do to increase household
  saving?
• One often-proposed idea is to decrease capital
  gains tax

30
Figure 6 An Increase In Savings
31
Governments Budget Deficit

• A increase in government purchases tends to
  raise interest rates.
• High interest rates discourage business
  investments.
• Crowding out effect
• So, to induce businesses to invest more,
  government should reduce its purchases.
• Shrinking deficit or rising surplus tends to
  reduce interest rates and increase investment.
• However, the effect on economic growth depends on
  how the budget changes.

32
Human Capital and Economic Growth

• Human capital
• Skills and knowledge possessed by workers
• An increase in human capital works like an
  increase in physical capital to increase output
• Causes production function to shift upward
• Raises productivity and increases average
  standard of living
• Human capital investments
• Education

33
Technology and Economic Growth

• Technological development is the key to
  sustaining economic growth
• The law of diminishing returns to capital
• Solow economic model
• Endogenous growth theory
• Technological change is not random but determined
  by factors in the market system.
• The principle that marginal cost equals marginal
  revenue in profit maximization applies in the
  determination of the amount of knowledge
  investment firms would like to make.

34
Technology and Economic Growth

• New technology affects economy in the way that it
  enables any given number of workers to produce
  more output.
• Production function shifts upward.
• Government policies that encourage investment in
  technology
• Protecting intellectual property rights
• Subsidizing research and development
• Subsidizing education
• Entrepreneurship