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Chapter 26

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Queen's University
ECON 110
Ian James Cromb

Chapter 26: Long-Run Economic Growth The Nature of Economic Growth  Economic growth is sustained, long-run increases in the level of real GDP Benefits of Economic Growth Rising Average Material Living Standards  Families can expect to earn more in the future with annual growth rates in income  An increase in income often leads to changes in the pattern of the family’s consumption o Extra money buys important amenities and also for more saving for the future  Economic growth that raises average income tends to change the whole society’s consumption patterns, shifting away from tangible goods to services  Higher income often leads to a demand for a cleaner environment Alleviation of Poverty  Many poor members of the population are not even in the labour force and are unlikely to share in the higher wages that are the primary means the gains of growth are distributed o Redistribution policies will be needed to reduce poverty  It’s possible to reduce income inequalities while simultaneously allowing incomes to rise Costs of Economic Growth The Opportunity Costs of Economic Growth  Growth requires heavy investment of resources in capital goods and activities like edu. o Often yield no immediate return in terms of goods and services for consumption, promising more goods and services in the future o Must sacrifice current consumption to get more consumption in the future Social Costs of Economic Growth  The process of economic growth renders some machines obsolete and also leaves the skills of some workers partly obsolete  A high growth rate usually requires rapid adjustments of the labour force, which can cause much upset and misery to some of the people affected by it Sources of Economic Growth 1. Growth in the labour force – may be caused by a growth in population or by increases in the fraction of the population that chooses to participate in the labour force 2. Growth in human capital – can increase through formal education or on-the-job training and can be thought of as the quality of the labour force 3. Growth in physical capital – the stock of physical capital increases only through the process of investment  includes improvements in the quality of the physical capital 4. Technical improvement – brought about by innovation that introduces new products, new ways of producing existing products, and new forms of organizing economic activity Established Theories of Economic Growth Focus on the Long Run  The theory of economic growth is a long run theory – concentrates on the growth of potential output over long periods of time, not short-run fluctuations of output  Recall, equilibrium level of real GDP in the simplest macro model was such that real GDP was equal to desired expenditure which was equal to consumption plus investment o Y = C + I  I = Y – C or S (desired saving) = I Investment, Saving, and Growth  Complicate the model by adding a gov’t sector the purchases goods and services (G) and collects taxes (T) – national saving is the sum of private saving an gov’t saving  Desired saving is the difference between disposable income and desired consumption  Private Saving = Y* – T – C Public Saving = T – G  National Saving = NS = Y* – T – C + (T – G)  NS = Y* – C – G o Increase in consumption or gov’t spending implies a reduction in national saving  With real GDP equal to Y*, the equilibrium interest rate is determined where national saving equals desired investment o Excess supply of saving drives the real interest rate down o Excess demand for investment drives the real interest rate up An Increase in the Supply of National Saving  In the long run, an increase in the supply of national saving pushes down the real interest rate and encourages investment o Higher rate of investment leads to a higher future growth rate of potential output An Increase in Investment Demand  In the long run, an increase in the demand for investment pushes up the real interest rate and encourages more saving by households o The higher rate of saving (and investment) leads to a higher future growth rate of potential output Investment and Growth in Industrialized Countries  Model predicts that countries with high rates of investment are also countries with high rates of real GDP growth  It is clear, figure 26-5 page 649, that there is a positive relationship between investment rates and growth rates as suggested by the model Neoclassical Growth Theory  Much of Neoclassical growth theory is based on the idea that the (above) sources of economic growth can be connected by the aggregate production function  The aggregate production function shows the relationship between the total amount of each factor of production employed in the nation and the nation’s total GDP o L, total amount of labour; K, physical capital employed; H, the quality of labour’s human capital; T, the state of technology; GDP, the nation’s total level of output o Can be expressed as: GDP = F (L,T,H)  Aggregate because it relates the economy`s total output to the total amount of factors that are used to produce that output – tells us how much GDP will be produced for given amounts of L, K, H, and T  F Ts a simple way of indicating that the function relating L,K, or H to GDP depends on the state of technology. Properties of the Aggregate Production Function 1. Diminishing Marginal Returns  The law of diminishing returns states that if increasing quantities of a variable factor are applied to a given quantity of fixed factors, the marginal product of the variable factor will eventually decrease 2. Constant Returns to Scale  Constant returns to scale is a situation in which output increases in proportion to the change in all inputs as the scale of production is increased Economic Growth in the Neoclassical Model 1. Labour-Force Growth  Labour-force growth with population growth – more labour used = more output produced  For a given shock of capital, the law of diminishing returns tells us that sooner or later, each additional unit of labour employed will cause smaller additions to GDP o Although economic growth continues, material standards of living are actually falling because average GDP per person is falling 2. Physical and Human Capital Accumulation  Law of diminishing returns implies that eventually each successive unit of capital will add less to total out than the previous unit of capital  However, output per person determines living standards, not output per unit
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