Chapter 26: long-run economic growth
26.1 The nature of economic growth
The aspect of economic growth is annual growth rate, the index of real per capital GDP and
measure of productivity which is the index of real GDP per employed worker.
Though real GDP is an accepted measure of the amount of the annual economic activity, it is not
a good measure of average material living standards because it does not take into account the
growth in the populationmore income is not necessarily better if more people have to share
Economic growth: sustained long-run increases in the level of real GDP.
Benefits of Economic Growth
Rising average living standards
Economic growth is a powerful means of improving average material living standards
A family often fines that an increase in its income can lead to changes in the pattern of its
consumptionextra money buys important amenities of life and also allows more saving for the
Similarly, growth that raises average income tends to change the whole societys consumption
pattern, shifting away from tangible goods and toward services.
Another example of how economic growth can improve living standards involves environmental
Economic growth provides higher incomes that often lead to a demand for a cleaner
environment, therefore leading higher average living standards that are not directly captured by
measures of per capital GDP.
Alleviation of poverty:
Many of the poorest member of the population are not the event in the labor force and hence
are unlikely to share in the higher wages that, along with profits, are the primary means by
which the gains from the growth is distributed. For this reason, even in growing economy
redistribution policies will be needed if poverty is to be reduced.
When there is economic growth and when some of the increment in income is redistributed
through active government policy, it is possible to reduce income inequalities while
simultaneously allowing all incomes to rise. It is much easier for a rapidly growing economy to
be generous to word its less fortunate citizens or neighbors then it is for a static economy
Costs of economic growth
The opportunity cost of economic growth: Economic growth requires heavy investment of resources and capital goods, as well as in such
activities as education. Often these investments yield no intermediate return in terms of goods
and services for consumption; therefore, they imply the sacrifices are being made by the current
generation of consumers.
Economic growth, which promises more goods and services tomorrow, is achieved by
consuming fewer goods today. For the economy as a whole, this sacrifice of current
consumption is the primary cost of growth.
Social costs of economic growth
One aspect of growing economy is accounted by existing firms expanding and producing more
outputs, hiring more workers, and using more equipments and intermediate goods.
Another aspect of growth is that existing firms are overtaken made obsolete by new firms, old
products are made obsolete by new products, and existing skills are made obsolete by new
The process of economic growth renders some machines obsolete and also leaves the skills of
some workers partly obsolete.
A high growth rate usually requires rapid adjustment in the labour force, which can cause much
upset and misery to some of the people affected by it.
Sources of economic growth
Economic growth has 4 fundamental determinants:
1. Growth in the labour force: this may be caused by growth in population or increase in the
fraction of population that chooses to participate in the labour force.
2. Growth in human capital: Human capital is the set of skills workers acquire through formal
education and on the job training. Human capital can be thought of as the quality of the labour
force, but because of its importance we will treat it as a separate factor of production from
3. Growth in physical capital: the stock of physical capital such as factories, machines electronic
equipments, and transportation and communication facilities, increases only through the
process of investment. We include here improvements in the quality of the physical capital.
4. Technological improvement: this is brought about the innovation that introduces new
products, new ways of producing existing products, and new forms of organizing economic
26.2 established theories of economic growth
Focus on the long-run The theory of economic growth is a long-run theory. It concentrates on the growth of
potential output (Y*) over long periods of time, not on short-run fluctuations of output
The equilibrium level of real GDP in that model was such that real GDP was equal to desired
aggregate expenditure which in the simplest form was equal to desire consumption and desired
expenditure: Y = C + I
We can re arrange saying that Y-C=I so S=I meaning that saving equals to desired investments.
Therefore, taking the real interest as given in our short-run model, the condition that desired
saving equal to desired investment determined the equilibrium level of real GDP.
In the long run, real GDP is equal to Y*, we can use the saving/investment equilibrium condition
by turning it on its head. That is we can take the level of output as given (at Y*) and use the
condition that desired saving equals desired investment to determine the equilibrium real
Investment, saving and growth
The complicated model of Real GDP is the addition of government purchases of goods and
services (G) and collects taxes (T).
National savings is the sum of the private saving and public (government) saving.
Desired private saving is the difference between disposable income and desired consumption.
With real GDP equal to Y* in the long run, desired private saving is equal to : private saving= Y*=
Public savings is equal to the combines budget surpluses of the federal, provincial and municipal
government: Public saving= T - C
National saving is therefore equal to : NS=Y*-T-C+(T-G) NS= Y* - C G
For a given level of output in the l