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Chapter 26

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University of British Columbia
ECON 102
Ying Kong

Long-Run Economic Growth 3/15/2013 4:53:00 AM THE NATURE OF ECONOMIC GROWTH - one of the most important reasons both GDP and per capita GDP increase over many years is growth in productivity - economic growth is term that economists usually reserve for describing sustained or long-run increase in real GDP - small average annual growth rate seems insignificant year to year, but is growth rates are sustained over long periods, they have a profound influence on material living standard from one generation to the next Benefits of Economic Growth - Difference between:  increase in average living standards that economic growth brings automatically  reduction in poverty economic growth makes possible but still requires active policy Rising Average Living Standard - increase in income for a family changes consumption and saving patterns - economic growth that raises average income switches society consumption from tangible goods to services (approx. 70% of consumption in developed countries) - in developing countries most recourse are put towards needs of survival - richer countries have the luxury of attaining these needs and devote significant resources to environmental protection  leads to increased living standard not associated with GDP Alleviation of Poverty - in a growing economy redistribution policies are needed to reduce poverty - rapid growth makes this easier - when there is economic growth, and some increment of income is redistributed (by gov), it is possible to reduce poverty while maintaining income increase Costs of Economic Growth 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** Social Cost of Economic Growth ** The process of economic growth renders some machines obsolete and the skills of some workers partly obsolete** - a high growth rate usually requires the rapid adjustments in the labour force, which can cause misery to people affected by it  it is these people who benefit least form the long-term growth Source of Economic Growth Economic growth has four fundamental determinants:  Growth in labour force o Caused by increase in population or increase people who choose to work  Growth in human capital o Increase by education or job training o “quality” of labour  separate from quantity  Growth in physical capital o Only increase via investment o Quality of physical capital  Technological improvement o Innovations resulting in new products o New ways of producing old products o New forms of organizing the economy ESTABLISHED THEORIES OF ECONOMIC GROWTH Focus on the Long Run ** The theory of economic growth is a long-run theory. It concentrates on the growth of potential output over long periods of time, not short run fluctuations of output around potential** Y = C + I  Y – C = I  S =I *ASSUMPTIONS:  Y=Y*  No NX  I-rate is endogenous - in the long run, with Y=Y*, we can take the level of output as given (at Y*) and use the condition that S=I to determine the real equilibrium interest rate Investment, Saving, and Growth - National savings = private savings + public (G) savings Private Saving = Y* - T – C Public Saving = T – G National Saving (NS) = (Y* - T – C) + (T – G)  Y* - C – G - for a given level of output, an increase in household consumption or gov purchases reduces national savings National Saving Graph  AXIS o H = Loanable Funds ($) o V = Interest Rate  The NS curve is upward sloping because increase in i-rate causes decrease in consumption (causes more savings and upward movement along curve)  The I curve is downward sloping because increase in i-rate causes less investment ** In the long-run version of out macro model, with real GDP = Y*, the equilibrium interest rate is determined where desired NS = desire I** - i > i*  high interest rate  much less consumption = high saving  desired NS > desired I  excess loanable funds decreases price of credit/i-rate - i < i*  low interest rate  increase consumption = low saving (shift NS left)  desired NS < desired I  excess demand for loanable funds An Increase in the Supply of National Saving - national saving increase results from fall in C or G - NS increase right shift = excess loanable funds = lower i-rate - lower i–rate = I increase - new EQ **In the long run, an increase in the supply of national savings reduced real interest rate, encouraging more investment. Higher investment leads to a higher future growth rate of potential output** An Increase in Investment Demand - investment increases by technological improvements or gov tax incentives to increase investment - I curve increases and shifts right = increases i-rate = increase NS - new EQ ** In the long run, an increase in the demand for investment pushes up the real interest rate and encourages more household savings. Higher rate of saving (and investment) leads to higher future growth rate of potential output** SUMMARY 1. In 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. The EQ determines the flows of I and S. 2. An increase in the supply of NS will lead to a fall in the real i-rate and thus and increase in I. This is a shift in the NS curve and a movement along the I curve. 3. An increase in demand of I will lead to a rise in real i-rate and thus and increase in desired NS. This is a shift in the I curve and a movement along the NS curve. 4. A shift in either the NS or the I curve will lead to a change in the EQ real i-rate and to a change in the amount of economy’s resources devoted to investment. An increase in the EQ amount of I implies greater growth rate of the capital stock and thus a higher future growth rate of potential output. Neoclassical Growth Theory - the four forces of economic growth can be connected by the aggregate production function - aggregate production function is an expression for the relationship between:  total amount of labour (L)  physical capital (K)  quality of labor’s human capital (H)  state of technology (T) GDP = F (T, K, H) - tells us how much GDP will be produced for given amounts of labour, physical capital employment, and given levels of human capital for a given state of technology ** When discussing long-run economic growth, we focus on changes in potential output. We therefore interpret GDP in the aggregate production function as potential output** Properties of Aggregate Production Function - Assume we can combine human and physical capital to K, and technology is constant  focus on changes to K & L DIMINSHING MARGINAL RETURNS - labour force grows while capital stays constant - the amount that each new worker adds to total output is called labour’s marginal product - the operation of the law of diminishing marginal returns tells us that the employment of additional workers will eventually add less to total output that the previous worker did ** According to the law of diminishing marginal returns, whenever equal increases of one factor of production are combined with a fixed amount of another factor, the increment to total production will eventually decline** CONSTANT RETURNS TO SCALE - the Neoclassical aggregate production function displays constant returns to scale -if the amounts of labour and capital are both changed in equal proportions, with constant returns to scale, total output will be changed by that proportion Economic Growth in Neoclassical Model LABOUR FOR
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