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Chapter 26

Economics 102: Chapter 26

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University of British Columbia
ECON 102
Robert Gateman

ECON 102: Principles of Macroeconomics Chapter 26 26.1 The Nature of Economic Growth  GDP and per capita GDP increase over time as there is growth in productivity  Economic growth: sustained, long-run increases in the level of real GDP Benefits of Economic Growth:  There is a difference between increases in average living standards created from economic growth and reduction in poverty that economic growth makes possible (still requires active policy) Rising Average Material Living Standards:  Economic growth is a powerful means of improving average material living standards o Increases in family income can lead to changes in the pattern of consumption o Extra money buys amenities of life and also increases saving for the future  Richer countries are able to deal with environmental impact, while poorer countries cannot afford to Alleviation of Poverty:  The poor do not benefit from economic growth as they are not in the work force o Even in a growing economy redistribution policies are needed to reduce poverty o It is easier to have redistribution policies in a rapidly growing economy Costs of Economic Growth:  Economic growth does have some real costs The Opportunity Cost of Economic Growth:  Growth requires heavy investment of resources in capital goods, and other areas such as education o These investments often have no immediate return, but rather long-term effects  Implies sacrifice in the short-term for the hope of long-term economic growth  In an economy with high investment rates, the growth rate will simultaneously increase o Sustained growth will lead to higher consumption in the long-term but lower in the short-term Social Costs of Economic Growth:  Growth also accounts for existing firms expanding and producing more output o Hiring more workers, using more equipment and intermediate goods  Existing firms may also be made obsolete by new firms o Old products and skills are made obsolete by new ones  A high growth rate requires rapid adjustment in the labour force o Leads to job loss and a higher educated workforce with the required skill sets Sources of Economic Growth: 1. Growth in the labour force: may be caused by increases in the population, or increases in the workforce ECON 102: Principles of Macroeconomics 2. Growth in human capital: thought of as the quality of the workforce a. Human capital: set of skills workers acquire through formal education and on-the-job training 3. Growth in physical capital: stock of physical capital increases through the process of investment a. Also includes increases in the quality of the physical capital 4. Technological improvements: brought about by innovation that introduces new products, new ways of producing existing products and new forms of organizing economic activity 26.2 Established Theories of Economic Growth Focus on the Long-Run:  Theory of economic growth is a long-run theory which concentrates on the growth of Y* over long periods of time, not on short-run fluctuations of output around potential  o In equilibrium, desired saving equals desired investment Investment, Saving and Growth:  National saving: sum of private saving and public (government) saving  Desired private saving: difference between disposable income and desired consumption  With real GDP equal to Y* in the long-run, desired private saving is equal to: o o o o  In the long-run, an increase in household consumption or government purchases must imply a reduction in national saving  National saving as a function of the real interest rate o Vertical axis: real interest rate, horizontal axis: loanable funds ($) o National saving (NS) curve is upward sloping, investment demand curve is downward sloping  In the long-run, the equilibrium interest rate is determined where desired national saving equals desired investment  At high interest rates above (I*), the amount of desired saving exceeds the amount of desired investment, and this excess supply of loanable funds pushed down the price of credit (the real interest rate)  At interest rates below I*, the quantity of desired investments exceeds the quantity of desired savings, and this excess demand for loanable funds pushes up the real interest rate An Increase in the Supply of National Saving:  Increases in NS happen from either household consumption (C) falls or government purchases (G) fall o Taxes also could rise, which reduces the level of consumption o Decline in C or G means that NS rises at any real interest rate and NS shifts to the right ECON 102: Principles of Macroeconomics  Increases in NS leads to an excess supply of loanable funds and thus a decline in the real interest rate o As interest rates fall, firms decide to undertake more investment projects  The economy will move to a new equilibrium (more resources are needed for investments)  The country's capital stock is rising at a faster rate  Higher rate of investment leads to higher future growth rate of Y*  In the long-run, increases in NS reduce the real interest rate and encourages more investment o The higher rate of investment leads to a higher future growth rate of Y* An Increase in Investment Demand:  Increase in desired investment might be cause by technological improvements that increase the productivity of investment goods or by a government tax incentive to encourage investment  Increase in investment demand creates an excess demand for loanable funds and leads to a rise in the real interest rate o Rise in the interest rate encourages households to reduce current consumption an increase savings o The new equilibrium will show that both the interest rate and investment are higher  Greater investment means faster growth in the economy's capital stock, thus a higher future rate of growth of potential output  In the long-run, increases in investment demand pushes up the real interest rate and encourages more saving by households o Higher rates of saving leads to higher future growth rates of potential output Summary: 1. In the long-run equilibrium, with Y=Y*, the condition that desired national saving equals desired investment determines the equilibrium interest rate in the market for loanable funds 2. An increase in the supply of NS will lead to a fall in the real interest rate, increase in the amount of I a. This is a shift of the NS curve and a movement along the I curve 3. An increase in the demand for I will lead to a rise in the real interest rate and increases in NS a. Shift of the I curve and a movement along the NS curve 4. A shift in either NS or I curves will lead to a change in the equilibrium real interest rate and to a change in the amount of the economy's resources devoted to investment a. An increase in the equilibrium amount of I implies a greater growth rate of the capital stock and thus a higher future growth rate of potential output Investment and Growth:  Countries with high rates of investment are also countries with high rates of real GDP growth  There is a positive relationship between investment rates and growth rates Neoclassical Growth Theory: ECON 102: Principles of Macroeconomics  Based on the idea that the four forces of economic growth can be connected by what is called the aggregate production function  Aggregate production function: relationship between the total amount of each factor of production employed in the nation and the nation's total GDP o An expression for the relationship between the total amount of labour (L) and
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