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Chapter 26

Chapter 26 Notes

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ECON 110
Ian James Cromb

Chapter 26 Notes – Long-Run Economic Growth  The average standard of living is higher when growth in real per capita GDP 26.1 – The Nature of Economic Growth  Real GDP is not a good measure for average living standards because it doesn’t take population into account  We use real per capita GDP to measure this, which is based on growth in productivity, and real GDP per worker  Economic Growth: sustained, long-run increases in the level of real GDP Benefits of Economic Growth  Rises in income change consumption patterns, more spent on leisure goods and savings, more government spending on public amenities  Higher income countries are more concerned with the environmental issues, which contributes to living standards as well  Some (unemployed) don’t benefit directly from higher wages, but benefit from an increased ease in redistribution policies with raised generosity Causes of Economic Growth  Current consumption is the primary cost of economic growth-we may consume more goods tomorrow by consuming fewer goods today  Economic growth renders some machinery and workers (out-dated skills) obsolete  Some say costs of economic growth are a relatively small price to pay, but they are unevenly distributed Sources of Economic Growth 1. Growth in the labour force: population growth or growth in population that chooses to participate in the work force 2. Growth in human capital: human capital (set of skills workers aquire through formal education and on-the-job training) is increased with formal or on-the-job training and is thought of as the quality of the labour force 3. Growth in physical capital: (factories, machines, transport, and communication facilities) increase through investment. Improvements in quality of physical capital 4. Technological improvements: innovation for new products, ways of production, and ways to organize economic activity 26.2 – Established Theories of Economic Growth Focus on the Long Run  Theory of economic growth focuses on long-run, and thus growth of potential output  Y = C + I, Y – C = I, S = I  So desired saving equals desired investment, determining the equilibrium level of GDP  We now take the interest rate as an endogenous variable Investment, Saving, and Growth  National saving is the sum of private savings (difference between disposable income and desired consumption) and public saving (budget surplus of combined levels of government)  National Saving = NS = Y* - T – C + (T – G)  NS = Y* - C – G  NS is upward sloping because increases in interest lead to reductions in consumption, especially big-ticket items (steep, responds only modestly)  I is downward sloping since real interest rate reflects the opportunity cost of using funds for investments  Equilibrium is where desired national savings meet desired investment  In the long run, and increased supply in national savings reduces the real interest rate and encourages more investment. The higher rate of investment leads to a higher future growth rate of potential output  Increase in demand may be caused by technological improvements or government tax incentive  In the long run, increased demand for investments brings up the real interest rate and encourages savings which leads to higher future rate of potential growth  Any increase in equilibrium amount of investment means a greater growth of capital stock and higher growth of potential output Investment and Growth in Industrialized Countries  Correlation between growth in investment and growth in potential output proven by country over time Neoclassical Growth Theory  Based on the idea that four forces of economic growth related with the aggregative production function  Aggregate Production Function: relationship between labour (L), physical capital (K) employed, quality of labour’s human capital (H), and state of technology (T)  GDP = F TL, K, H)  FT, the production function, indicates how much GDP is produced for given amounts of labour, physical capital and human capital, given a certain level of technology  Two key aspects of the Theory are… o Diminishing marginal returns when either factor is increased on its own. Law of Diminishing Marginal Returns: if increasing quantities of a variable factor are applied to a given quantity of fixed factors, marginal product of variable factor will eventually decrease
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