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22. Economic Growth.docx

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Rizwan Tahir

Chapter 22 – Economic Growth  Real GDP per person in Canada tripled in 50 years between 1958 and 2008.  Incomes have tripled in the 13 years between 1995 and 2008. The Basics of Economic Growth  Economic growth: sustained growth of production possibilities; increase in real GDP over a period  Economic growth rate is the annual % change of real GDP that tells us how fast the total economy is expanding  shows potential changes in the balance of economic power among nations  Does not tell us about changes in the standard of living, which depends on real GDP per person  GDP growth rate minus population growth rate = real GDP / population The Magic of Sustained Growth  Sustained growth of real GDP per person can transform a poor society into a wealthy one because economic growth is like compound interest (vs. simple interest)  Simple interest: pays interest only on the principal - $1,000 at 6% interest  worth $1,060 after one year, $1,120 after two years, $1,180 after three Compound interest (growth)  The Rule of 70: the number of years it takes for the level of a variable to double  70 divided by the (constant) annual % growth rate of the variable.  If original sum + earned interest becomes “principal” at the start of the next period, we compute total future value using compound interest - use 10% interest, $1,000 original deposit (investment) - After one year, have $1,000 + $100 = $1,100 - After two years, have $1,100 + $110 = $1,210 T - after T years, compound value of $1,000 at 10% interest = $1,000*(1+0.1) Compound Interest Formula  Call PV the value of a sum today (present value)  Call FV the compound value of the sum at a stated date in the future (future value)  Call i the interest rate  as a fraction, so 10% interest implies i = 0.10  Call T the number of years (compounding periods) between “today” and the relevant future date T  Generally, the compound FV of a present sum compounded over T periods at i is FV = PV(1+i)  For growth analysis, rewrite : V T V (0+g) T - V0is value at the start (before any growth) - VTis value after T periods - ‘g’ is the constant growth rate  Doubling implies that V =T2*V , 0r V / T = 20 Rule of 70 – not magic  Exact Time to Double  Compute doubling time (of GDP, GDP/capita, or asset value)  Suppose quantity grows at CONSTANT rate “g”: Exact vs. Rule of 70 Doubling Time Rule of 70 approximations  Exact time it takes for quantity growing at constant rate ‘g’ per period to double in size: - TDouble ln2 / ln(1+g)  ln2 = 0.7  TDouble= 0.7/g  ln(1+g) = g (for g≤0.1)  Multiply top and bottom by 100, doubling time is about 70/growth rate as % Accounting for changes in GDP  We can express the flow rate of GDP as the product of three components  F is the amount of factors, and F is the amount E of employed factors  Any change in GDP must be the result of a change in factor supply, a change in factor utilization, or a change in productivity Economic growth trends  The gaps between the real GDP per person in Canada and in poor countries have widened Growth in the Canadian Economy  From 1926 to 2007, growth in real GDP per person averaged 2.1% a year.  Real GDP per person fell during the Great Depression and rose rapidly during World War II.  Growth was most rapid during the 1960s and averaged 3.3% a year.  Growth slowed during the 1970s and slowed again in the 1980s, but sped up after 1996. Real GDP growth in World Economy  US has the highest real GDP per person  Canada had the second highest real GDP per person in 2008  Japan grew the fastest, but then stagnated in 1990s  Modest differences in economic growth rates over years bring huge differences in standard of living How Potential GDP grows  Economic growth is when real GDP increases sustained, year-on-year increase in potential GDP.  Potential GDP: quantity of real GDP at full-employment  Q labour employed = only variable FoP  To determine potential GDP we use a model with two components 1. The aggregate production function (Neoclassical) - Production possibilities frontier: all combinations of goods and services that can be produced - Law of diminishing returns: more leisure we forgo = greater quantity of labour and of real GDP produced  but real GDP increases by successively smaller amounts  marginal product falls with each successive unit of variable factor added with a fixed amount of another factor - Aggregate production function: relationship of how real GDP changes as Q labour changes an increase in Q labour (less leisure) brings movement along the PPfrontier and increase real GDP - Based on idea that the 4 sources of economic growth can be represented with an aggregate production function GDP = F (LKT) where L is labour, K is physical capital, H is quality of human capital, T is state of technology, and F Teflects assumption that changes in T change the function. - Key aspects of the Neoclassical aggregate production function 1. Displays diminishing marginal product of both K and L (when changed in isolation): capital accumulation brings smaller increases in real per capita GDP 2. Displays constant returns to scale (when both K and L are changed in equal proportions): GDP increases, but per capita GDP will be constant - Marginal product = change in real GDP / change in labour hours - Whenever diminishing returns applies, increases in population lead to increases in GDP, but declines in per capita GDP  thus falling average living standards 2. The aggregate labour market - Determines the quantity of labour hours employed and the quantity of real GDP supplied - Real wage rate: money or nominal wage rate divided by price level  Q goods and services that an hour of labour earns. Money wage rate = number of dollars an hour of labour earns. - Demand for labour: relationship between QD of labour and real wage rate. QD = # labour hours hired by firms during a period. Real wage rate influences QD because what matters to firms is how much output they must sell to earn $. QD increases as real wage rate decreases  curve slopes down because of diminishing returns  firms hire more only if real wage rate falls to match fall in extra output produced by that labour - Supply of labour: relationship between QS of labour and real wage rate. QS = number of labour hours that all households plan to work during a given period. QS increases with real wage rate. - Labour equilibrium: price of labour = real wage rate. S and D eliminate a shortage/surplus of labour by changing real wage. Shortage means real wage rate rises, surplus means real wage falls.  Production function tells us the Q of real GDP that a given amount of labour can produce. The Q real GDP produced increases with Q labour. At full employment, and the Q real GDP = potential GDP. What makes potential GDP grow Growth of supply of labour  When supply of labour grows, the supply of labour curve shifts right  Quantity of labour = number of workers employed x average hours per worker  Number employed = employment-to-population ratio x working-age-population  Q labour (aggregate hours) changes due to 1. Average hours per worker (decreased as workweek became shorter) 2. Employment to population ratio (increased with more women) 3. The working age population  Growth in labour supply comes from growth in working-age population. - In the LR, the working age population grows at the same rate as the total population.  Effects of population growth: brings growth in labour supply (right shift) and real GDP, but does not change demand for labour or the PF. With an increase in labour supply, the equilibrium real wage rate falls and aggregate hours increase  more output and potential GDP increases.  The population increase and diminishing returns decreases potential GDP per hour of labour Growth of labour productivity  Labour productivity: quantity of real GDP produced by an hour of labour. Real GDP divided by aggregate labour hours.  growth means real GDP per person grows and a rising standard of living  Effects of rising labour productivity: production possibilities expand, quantity of real GDP that any given Q of labour can produce increases. Firms are willing to pay more for a given number of hours of labour, so demand for labour also increases  no change in LS  real wage rate rises and QS (and aggregate hours) increases. Potential GDP rises due to productivity& increases in employment.  Increases potential GDP per hour as well  Rise in aggregate labour hours is a consequence of rise in productivity (not a cause)  Real GDP increases to point B on the new production function, but as equilibrium quantity increases, potential GDP increases to point C (see graph below) Why labour productivity grows Preconditions for labour productivity growth  The fundamental precondition is the incentive system created by firms, markets, property rights, and money. With the preconditions, 3 things influence labour productivity growth pace 1. Physical capital growth - As the amount of capital per worker increases, labour productivity rises - Production processes that use hand tools can create pretty things, but production methods that use large amounts of capital per worker are much more productive 2. Human capital growth - Human capital: accumulated skill and knowledge of humans - Most fundamental source of labour productivity growth - Grows when a new discovery is made, and when more people learn how to use past discov
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