Econ 1021 Chapter 7: Chapter 7
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Department
University College - Economics
Course
University College - Economics Econ 1021
Professor
Bandyopadhay Sudeshna
Semester
Spring

Description
Chapter 7: Economic Growth I. History of Economic Growth A. Origins 1. About 300 years ago … a fundamental change occurred a. Technological advances and entrepreneurial innovations ushered in a new era of sustained (long run) economic growth, changing every aspect of how we live… b. According to many economists: Long run economic growth and the ensuing increase in living standards – why it occurs and how to achieve it – is by far the most important issue in Macroeconomics. c. From the year 1000 to 1820 AD the advancement in per capita income was a slow crawl — the world average rose about 50 per cent. Most of the growth went to accommodate a fourfold increase in population. d. Since 1820, world development has been much more dynamic. Per capita income rose more than eightfold, population more than fivefold. (using 1990 real dollars) e. Only in recent times has rate of GDP growth outpaced population growth 2. GDP Growth Per Capita a. Not much movement till 1400, then slow movement till 1800s, then remarkably fast movement b. Manufacturing leaving US around the early 80s, around when China increases take-off c. Brazil only 1% less in growth rates, but are compounded over large periods of time (compared to other top nations form 1870-2003) d. Seemingly small rate of improvement sustained over time can have HUGE influence 3. Observations on GDP Growth Per Capita for Major Nations a. The US was already a relatively wealthy industrialized country in 1870 • US real per capita GDP grew 12 times between 1870 and 2003. In Japan, real per capita GDP grew 28 times over the same period 1870 – 2003 b. Significant part of the growth is post 1950 especially in Japan and post 1979 in China c. Caution: Older data are not as reliable and is not strictly comparable to newer data (how does a Jet compare with a stagecoach?) d. Small differences in Growth rates matter • Brazil was richer than Japan in 1870. • However, over the period 1870 – 2003, Japan had the highest growth rate of 2.6% and Brazil’s was 1.6% • This 1% differential was enough to make Japan’s real per capita GDP be more than 3 times as large as Brazil’s in 2003. B. Quantification 1. **Purchasing Power Parity (PPP) a. When comparing GDP numbers across nations, we would need to convert them to the same currency b. Method 1: Use official exchange rates c. Method 2: Use PPP exchange rates – the rate at which the currency of one country would have to be converted into that of another country to buy the same amount of goods and services in each country d. Ex: If a hamburger is selling in London for £2.89 and in New York for $4.93 (data current as of Jan 2016), this would imply a “Big Mac” exchange rate of £2.89 ≡ $4.93, implies £1.00 ≡ $1.70588 • The official exchange rate (Feb 2016) is £1.00 ≡ $1.43 • So, at official exchange rates you would pay $2.89 x 1.43 = $4.13 for a hamburger in London. • PPP exchange rate (Feb 2016) is £1.00 ≡ $1.7059 • Pound is overvalued vis-à-vis the dollar e. Big Mac Index • The Big Mac index was invented by The Economist in 1986 as a lighthearted guide to whether currencies are at their “correct” level • The concept of a “Correct” level based on the theory of purchasing-power parity (PPP), is the notion that in the long run exchange rates should move towards the rate that would equalize the prices of an identical basket of goods and services (in this case, a burger) in any two countries • For example, the average price of a Big Mac in America in January 2016 was $4.93; in China it was only $2.68 at market exchange rates • So the Big Mac index says that the yuan was undervalued by 46% = [(2.68- 4.93)/4.93] 2. Compounding Interest a. Concept of Compound Interest: N=P(1+r) t • Simple interest (N = P(1 + rt)) gives you a rate of return on the principal • Compound interest rate helps you earn interest on all accrued interest • P is the principal, r is the interest rate, t is the time elapsed t b. If the starting year is year 1, then the value of N in Year t+1 will be: $10 x (1+r) c. Reason why small growth rates matter • The payment of interest is not just on the original deposit but also on all previously accumulated interest • Economic growth rates are similar to compound interest rates • Government policies that affect the long-term growth rate even by a small amount will have a major economic impact 3. Rule of 70 a. How long does it take for per capita real GDP to double itself? 72 • 𝑛 = 𝑎𝑛𝑛𝑢𝑎𝑙 𝑔𝑟𝑜𝑤𝑡ℎ 𝑟𝑎𝑡𝑒 • Where n = number of years it takes for the variable to double itself • Some economists use 69, 69.3 or 70; works for small and moderate growth rates that are positive • US took 72/1.9 = 38 years to double per capita real GDP b. FV = PV (1+r) t • Where FV = future value in t+1 years of a present value PV at r% rate of interest. • Doubling implies FV = 2PV • So 2 = (1+r) Taking natural logs on both sides we get: ln2 = t ln(1+r) • Assuming r is small, ln(1+r) by Taylor’s expansion is approximately equal to r and ln2=0.693. • So t is approximately equal to = 69.3/r% c. But we usually use 72 because it has more factors (divisible by more common interest rates) II. Understanding Economic Growth A. Labor Productivity 1. Average Labor Productivity a. We know that economic growth rates are measured by annual percentage change in Per capital Real GDP b. 𝑌 = ×𝑌 𝑁 𝑃𝑜𝑝 𝑁 𝑃𝑜𝑝 • Y=Real GDP; N=employed; POP = Total population c. Per capita real GDP (Y/POP) is the product of average labor productivity (Y/N) and share of population employed (N/POP) 2. GDP per capita increases when a. Output per worker (Y / N) increases (OR) b. The share of the population employed (N / POP) increases c. Between 1960 and 2007 • GDP per capita increased 172% • Output per worker increased 110% • The share of the population employed increased from 36% to 48% 3. Understanding Growth a. Share of population employed (N/POP) rose from 36% to 48% of the entire population because: • Increase in labor force participation of women • The share of working age population (age 16 – 65) in total population rose (coming of age of baby boomers and immigration). b. Rise in N/POP (share of population employed) is expected to slow down because: • Female LFPR has stabilized • Baby boomers will enter retirement around 2010 • Immigration not likely going to substitute for local population needs in labor (since not as high immigration recently) c. Hopes are on average labor productivity (Y/N) • In the long run, increases in output per person arise primarily from increases in average labor productivity • High labor productivity is not determined only by the willingness of the population to work hard B. Determinants of Average Labor Productivity 1. Human Capital and Average Labor Productivity a. Human Capital = the talents, education, training, and skills of workers raise productivity b. Human capital is the result of a combination of factors such as education, training, experience, intelligence, trustworthiness, initiative, etc. c. Can find average labor productivity APL by multiplying labor hours (units/hour) * hours worked in a given time d. Ex: Japan was practically destroyed after WWII. • The occupying US forces restructured the Japanese school system and encouraged all citizens to obtain a good education. • Even more than Germany, Japan emphasized on-the-job-training. With lifetime employment, employers invested heavily in worker training. • By 1980, Japanese manufactured goods were among the best in the world and its labor force, among the most skilled. e. No single criterion for what made success in one country (not ust a single factor switch, ie with human capital) 2. Physical Capital and Average Labor Productivity a. Physical Capital = worker productivity depends not only on their skills (human capital) but on the tools/machines (physical capital) they have to work with • An excellent surgeon needs his equipment to perform surgery • The average US worker today is backed by about $130,000 worth of physical capital – far more than 100 years ago and more than most other nations in the world. b. Ceteris Paribus, a greater quantity of physical capital per worker raises average/marginal labor productivity • We say, labor and capital are complements in production • However, physical capital is subject to diminishing returns • If labor and other inputs are held constant, then the greater the amount of physical capital already in use, the less an additional unit of capital will add to productivity. c. Diminishing returns to capital occurs if an addition of capital with other inputs held constant increases output by less than the previous increment of capital • Assumption: all inputs except capital are held constant • Result: output increases at a decreasing rate • When a firm has many machines, the most productive uses have already been filled • The increment in capital will necessarily be assigned to a less productive use than the previous increment • Principle of Increasing Opportunity Cost – Low Hanging Fruit Principle • Graphically, have a curve rising at a diminishing rate (concave down) d. Does more capital mean more productivity? • At the lower end of the real GDP per worker scale, yes, a strong positive correlation • At the higher end of the real GDP per worker scale, a weaker relationship 3. Natural Resources: Determinant of Average Labor Productivity a. Land and Other Natural Resources • Ceteris Paribus, an abundance of valuable natural resources (fertile land, rich mineral resources, etc) increases the productivity of workers and hence
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