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Chapter 26

ECON 295 Chapter 26: Chapter 26 notes.docx


Department
Economics
Course Code
ECON 295
Professor
Kenneth Ragan
Chapter
26

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Chapter 26
Long-Run Economic Growth
I) The Nature of Economic Growth
Economic growth: Sustained, long-run increases in the level of GDP.
This chapter will discuss three aspects of economic growth—real GDP, real per capita GDP, and
productivity.
A) Benefits of Economic Growth
a) Rising Average Material Living Standards
Economic growth through increase in average income.
Economic growth tends to change the whole society’s consumption patterns, shifting away from
tangible goods and toward services. In developed countries, services account for roughly 70%
of aggregate consumption.
Economic growth provides the higher incomes that lead to a demand for a cleaner environment,
thus leading to higher average living standards that are not directly captures by measures of per
capita GDP.
b) Alleviation of Poverty
Not everyone benefits equally from growth. Even in a growing economy, redistribution policies
will be needed if poverty is to be reduced.
A rapid growth rate makes the alleviation of poverty easier politically.
It is much easier for a rapidly growing economy to be generous toward its less fortunate citizens
—or neighbours—than it is for a static economy.
B) Costs of Economic Growth
a) The Opportunity Cost of Economic Growth
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.
Transferring resources from consumption to investment lowers current consumption (opportunity
cost) but raises growth and therefore future consumption.

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b) Social Costs of Economic Growth
The process of economic growth renders some machines obsolete and also leaves the
skills of some workers partly obsolete.
Workers may have great skills at age 25, but many will find that in another 25 years, their skills
will be at least partly obsolete.
A high growth rate usually requires rapid adjustments in the labour force, which can cause much
upset and misery to some of the people affected by it.
C)Sources of Economic Growth
Economic growth has four fundamental determinants:
1. Growth in the labour force. Growth in population or increases in the fraction of the
population that chooses to participate in the labour force.
2. Growth in human capital.
Human capital: The set of skills workers acquire through formal education and on-the-
job training.
Human capital = quality of the labour force
3. Growth in physical capital. The stock of physical capital (such as factories, machines,
electronic equipment, 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 by innovation that introduces new
products, new ways of producing existing products, and new forms of organizing
economic activity.
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II) Established Theories of Economic Growth
A) Focus on the Long Run
Assumptions: all factor-price adjustment has occurred, and thus real GDP equals
Y¿
.
The theory of economic growth is a long-run theory. It concentrates on the growth of
potential output over long periods of time, not on short-run fluctuations of output around
potential.
In equilibrium:
S=I
B) Investment, Saving, and Growth
Private saving
¿Y¿TC
Public saving
¿TG
National saving
¿Y¿CG
NS
is upward sloping as an increase in the interest rate is assumed to lead households to
reduce their current consumption, especially on big-ticket items and durable goods, such as
cars, furniture, and appliances, that are often purchased on credit.
is downward sloping, as desired investment is negatively related to the real interest rate—
the real interest rate reflects the opportunity cost of using these funds.
In the long-run version of our macro model, with real GDP equal to
Y¿
, the equilibrium
interest rate is determined where desired national saving equals desired investment.
a) An Increase in the Supply of National Saving
In the long run, an increase in the supply of national saving reduces the real interest rate
and encourages more investment. The higher rate of investment leads to a higher future
growth rate of potential output.
b) An Increase in Investment Demand
In the long run, an increase in the demand for investment pushed up the real interest
rate and encourages more saving by households. The higher rate of saving (and
investment) leads to a higher future growth rate of potential output.
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