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EC140
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Rizwan Tahir
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Economics

EC140

Rizwan Tahir

Winter

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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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