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EC140 8.docx

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Wilfrid Laurier University
Justin Smith

EC140 April 2 and 4 2013 Exam – 70 m/c, cumulative Economic Growth - Living standards, as measured by RGDP per person, will double roughly twice in your lifetime - What has caused this growth? How do we maintain this growth? - Do all countries grow at the same rate? If not, who do some grow fast and other slow? - Can economic growth continue forever? - These are some of the questions we hope to answer in this section of the course - Economic growth: sustained expansion of production possibilities measured as the increase in real GDP over a given period. o Economic growth = the growth of potential GDP over time Calculating Growth o Economic growth rate: annual percentage change of real GDP. o Growth Rate = [(RGDP – RtDP )/RGDP t-100 t-1 o Same formula as we used to calculate inflation but using real GDP, not CPI - Growth in Real GDP tells us how the entire economy is growing - But, does not tell us if more is available per person (ex. If real GDP is growing, but population grows faster, we’re actually sharing a larger quantity of GDP amongst a larger population, which makes people worse off) - Real GDP per person is a better measure of living standards. - Real GDP per person is real GDP divided by the population. - Real GDP per person grows only if real GDP grows faster than the population grows. - Real GDP per person is just an average; it does not represent how much everyone actually gets (there are income and wealth disparities among countries and regions) - Top 10% of the population owns most of the wealth and gets most of the growth The Mechanics of Growth - The numerical mechanics of growth in RGDP works just like growth of any other quantity - Works on the principle of compounding - Interest is accrued on the previous interest gained (grows faster over time) - Ex: Suppose you put $100 in a bank account with 10% interest, compounded annually. - At the end of year 1, you have: $100*1.1 = $110 - During year 2, you earn interest on the original $100, and on the $10 you gained in year 1 - At the end of year 2, you have: $110*1.1 = $100*1.1 + $10*1.1 = $121 - Compounding leads to large growth, even if the interest rate is very low - The accrued interest will be larger and larger every year 1 EC140 April 2 and 4 2013 Value of $100 after Compounding Over Time 7000 6000 5000 4000 D3000rs i=0.05 i=0.15 2000 1000 0 0 5 10 15 20 25 30 35 Years - 5% interest rate gets you about $500 after 30 years - With a 15% interest rate, your account grows exponentially over 30 years and you’ll end up with about $65,000 - The higher the interest rate, the higher the exponential growth of an account with compounding interest - The same logic is applied to Economic Growth - At a constant growth rate, the level of RGDP will rise by more every year (exponential growth) - Because you earn interest on the original principal, and on all past accrued interest - At higher growth rates, this is more pronounced - Rule of 70: describes the length of time it takes a number to double, given compounding - A tool to see how long it will take an investment to grow - Time to double ≈ 70/(annual percentage growth rate) - You can apply it to economies: estimate how long it will take for RGDP per capita (living standards) to double 2 EC140 April 2 and 4 2013 - A variable that grows at 7 percent a year doubles in 10 years. - A variable that grows at 2 percent a year doubles in 35 years. - A variable that grows at 1 percent a year doubles in 70 years. - Once you get to large growth rates, when the rate changes by 1, the doubling period doesn’t get much shorter Growth in the Canadian Economy - From 1926 to 2010, growth in real GDP per person in Canada: - Averaged about 2.0% a year. - At this rate, living standards will double twice in the average person’s lifetime - Real GDP per person fell during the Great Depression and rose during World War II. - Growth was most rapid during the 1960s - Averaged 3.3% a year. - Growth slowed during the 1970s and slowed again in the 1980s, but sped up after 1996. 3 EC140 April 2 and 4 2013 - Real GDP Growth in the World Economy o Japan grew rapidly in the 1960s, slower in the 1980s, and even slower in the 1990s. o Growth in Europe Big 4, the United States, and Canada has been similar. - The gaps between real GDP per person in Canada and in these countries have widened. o i.e. Richer countries started at a higher level, and have been growing faster o Canada’s GDP per person is 10x larger than that of less developed areas 4 nd th EC140 April 2 and 4 2013 Growth Rates of Various Countries Versus World 20 15 10 World Canada 5 China USA 0 Gro1970Rat1975 Re1980DP 1985 1990 1995 2000 2005 2010 -5 Year - Growth rates between 10-15% in China - The rest of the world is typically growing at a rate of 2% Growth Rates of High, Middle, and Low Income Countries 10 8 6 4 High Income 2 Low Income 0 Middle Income Gro1970Rate 1980 1990 2000 2010 -2 -4 -6 Year - High income countries grow slower than middle and low income countries - High income countries were hit harder by the recession 5 EC140 April 2 and 4 2013 How Potential GDP Is Determined - Economic growth is the sustained, year-on-year increase in potential GDP. o Recall: Potential GDP is the quantity of real GDP produced at full employment. - To determine potential GDP we use a model with two components: o The aggregate “production function” o The aggregate labour market - An aggregate production function tells us how much output we can get for some combination of inputs o I.e. how much can we produce with a given level of labour and machines? Y = A*F(L,K) o Y is output, L is labour, K is capital (e.g. machines), A is Total Productivity (technology), and F is some function o Turning inputs (machines and people), into outputs o You can combine capital and labour in certain ways to change output o In your text, when drawing the graph, we assume K (capital) is fixed at some level (and so is A) o Holding technology and capital fixed, what happens when you increase or decrease the amount of labour? o Diminishing marginal return of labour (the output you get from adding more workers eventually falls because you start running out of room and you hire less productive people)  Thus, we look at how Y (output) changes when L (labour) changes - This is the relationship between labour (L) and RGDP (Y) - An increase in labour increases RGDP. o Labour is measured in total hours, so it can rise by increasing people or hours per person - Y increases at a decreasing rate (diminishing marginal productivity) o Each additional hour brings a smaller increase in Y o Ex: imagine crowding more people on a single production line. People may bump into each other, lowering extra output with additional workers o Firms will initially hire the most productive workers; as they hire more, people become less and less productive 6 EC140 April 2 and 4 2013 Aggregate Labour Market - The Labour Market is where firms demand labour, and workers supply it - The “price” of labour is the real wage rate o The real wage rate is the nominal wage rate divided by the price level. It measures purchasing power of wages. (Measures pay in terms of the purchasing power of your pay rather than the amount of money you receive) o In competitive labour markets, the real wage equals the marginal product of labour  i.e. workers are paid per hour what they produce in that hour  At the very least, real wages are proportional to productivity  Nominal wages are equal to the amount that the firm can sell the output for - This figure shows the labour market - Suppliers of labour are individuals and demanders are firms - The demand for labour shows the quantity of labour demanded at each real wage rate. - The supply of labour shows the quantity of labour supplied at each real wage rate. - At the labour market equilibrium, the economy is at full employment. - Full employment means no cyclical unemployment, but there could be natural (structural or frictional) unemployment - To determine potential GDP, we first figure out full employment labour from the labour market - Then, we use the production function to see how much is produced at that level of output - In this case, 20 billion hours leads to a 1.2 trillion dollar potential GDP - Anything that changes the demand or supply of labour will change total production (potential GDP) 7 EC140 April 2 and 4 2013 What Makes Potential GDP Grow? - We will use the labour market and production function to show how certain forces lead to economic growth - These forces are: o Growth in the supply of labour o Growth in labour productivity Growth in the Supply of Labour - Quantity of hours supplied is: (# employed workers)*(average hours per worker) - But, # employed workers is: (Employment to pop ratio)*(working age pop) - So the quantity of hours depends on: o Hours per worker o Fraction of people employed (epop ratio) o Total working age population The Effects of Population Growth - In the real world, growth in hours supplied has come from growth in the working age population - A shortening of the work week (average hours per worker) and an increase in the employment to population ratio have roughly offset each other over time. - In the next few slides, we look at the effects of growth in the working age population within the model - Though RGDP increases, RGDP per person will fall if productivity does not also increase - With an increase in the working age population, the total pie grows but the to
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