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Long-Run Economic Growth

and

Rising Living Standards

Economic Growth

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• Long-run economic growth– Increase in real GDP per capita over time– Increase in the standard of living– Growth rates and the rule of 70

• Business cycle– Fluctuations about the long-run growth trend

– Recessions alternate with expansions.

Economic Growth

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Long-Run Economic Growth

• What determines the potential output?– Labor productivity or Productivity Amount of output one average worker can produce in an

hour

– Average hours of labor Number of hours one average worker spends at the job

– Labor force participation rate (LFPR) Fraction of population that wants to work

– Size of population

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What Determines the Potential Output?

• Breaking down the total output

Population Population

forceLabor

forceLabor

labor of hours Total

labor of hours Total

output Total output Total

Population LFPR hours Aeverage ty productiviLabor output Total

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What Determines the Potential Output?

• Review of some linear algebra

If Z = X ∙ Y, then % Δ Z ≈ % ΔX + % ΔY If Z = X / Y, then % Δ Z ≈ % ΔX - % ΔY

• Applying this rule to the equation of total output

Population% LFPR% hours Average% ty Productivi% output Total%

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Long-Run Economic Growth

• What matters for a rising standard of living is real GDP per capita (i.e. per person)

Since

- Total real output = Productivity x Average Hours x LFPR x Population

Then

- Real output per capita = Total output ÷ Population

Real output per capita = Productivity x Average Hours x LFPR

In terms of percentage growth rates

LFPR% hours Average% ty Productivi% capitaper Output %

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Long-Run Economic Growth

• A tendency in most developed countries is that average hours of labor are slowly decreasing

So our last simplification is to ignore changes in average hours in the equation

% Δ Output per person ≈ % Δ productivity + % Δ LFPR

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Growth in LFPR

Recall that

Population

ForceLabor LFPR

So, Population% - forceLabor % LFPR%

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Growth in LFPR

• Currently, U.S. Bureau of Labor Statistics predicts the employment growth rate to be 1% per year until 2010, about the same as the growth rate of population– If so, the % Δ LFPR ≈ % Δ Labor force - % Δ Population = 0

– Is there anything we can do to make the labor force grow faster than population, and thus increase the rate of economic growth?

• Yes Increase labor supply Increase labor demand

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Labor Market

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An Increase in Labor Supply

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An Increase in Labor Demand

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The U.S. Labor Market Over A Century

L1 Millions of Workers

Real Hourly Wage L1

S

W1

L1D

A

L2S

L2

L2D

BW2

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How To Increase Employment

• Supply side

– Cut income tax • Paying 40% of one’s income as taxes (federal, state, and local)

discourages work effort in the United States.• Tax cut would provide incentives to people to seek jobs• Labor supply curve shifts rightward

– Changes in government transfer programs• Reduce social benefits

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How To Increase Employment

• Demand side– Government policies that help increase skills of the

workforce or that subsidize employment

• government-sponsored training programs• aid to college students• employment subsidies to firms

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Growth in Productivity

• Recently, virtually all growth in the average standard of living can be attributed to growth in productivity

• The sources for the growth in productivity– Capital stock– Human capital– Technological development– Entrepreneurship

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Figure 4: Capital Accumulation and Labor Productivity

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Growth in the Capital per Worker

• One key to productivity growth is growth in nation’s capital stock – With more capital, a given number of workers can produce more

output than before

• Growth in capital stock will increase productivity as long as it increases amount of capital per worker

S i n c e f or ceLabor

s t ock capi t al Tot al per wor ker capi t al ,

f or ceLabor % -s t ock capi t al Tot al% per wor ker capi t al%

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Investment and the Capital Stock

• A stock variable measures a quantity at a moment in time.– Capital stock is a measure of total plant and equipment in

economy at any moment• A flow variable measures a process that takes place over a period of

time.– Investment is a flow variable

• Depreciation is decrease in the value of assets

– As long as investment is greater than depreciation, total stock of capital will rise.

– The greater the flow of investment, the faster will be the rise in capital stock.

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Saving and Investment

• Private saving

• Public saving

• Total saving = Private saving + Public saving

• In a closed economy,

)( TRTCYS private

GTRTS public )(

NXIGCYSSS publicprivate

IS

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The Loanable Funds Market

• Where households make their saving available to those who need additional funds

• Supply of loanable funds – household saving

• Demand of loanable funds – businesses and government

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The Loanable Funds Market

• Businesses’ demand for loanable funds is equal to their planned investment spending (Ip)– Funds obtained are borrowed, and firms pay interest on their loans

• Government’s demand for loanable funds– Budget deficit (G – T)

Excess of government purchases over net taxes

• Government’s supply for loanable funds– Budget surplus (T – G)

Excess of net taxes over government purchases

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Supply of Household Loanable Funds

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Business Demand for Loanable Funds

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The Demand for Funds

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Loanable Funds Market Equilibrium

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Targeting Businesses – Demand Side

Reducing business taxes• Corporate profits tax

– A cut in tax on profits earned by corporations

• Investment tax credit– A cut in taxes for firms that invest in certain favored types of capital

• Reducing business taxes or providing specific investment incentives can shift the investment curve (the demand curve in the loanable funds market) rightward

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An Increase In Investment Spending

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Targeting Households – Supply Side

• If households decide to save more of their incomes at any given interest rate– Supply of loanable funds curve will shift rightward

• What might induce households to increase their saving?– Greater uncertainty about economic future– Increase in life expectancy– Anticipation of an earlier retirement– Change in tastes toward big-ticket items– Change in attitude about saving

• Any of these changes—if they occurred in many households simultaneously—would shift saving curve to the right

• What can government do to increase household saving?– One often-proposed idea is to decrease capital gains tax

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Figure 6: An Increase In Savings

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Government’s Budget Deficit

• A increase in government purchases tends to raise interest rates.

• High interest rates discourage business investments.

•Crowding out effect

So, to induce businesses to invest more, government should reduce its purchases.

–Shrinking deficit or rising surplus tends to reduce interest rates and increase investment.

–However, the effect on economic growth depends on how the budget changes.

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Human Capital and Economic Growth

• Human capital– Skills and knowledge possessed by workers

• An increase in human capital works like an increase in physical capital to increase output– Causes production function to shift upward

• Raises productivity and increases average standard of living

• Human capital investments– Education

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Technology and Economic Growth

• Technological development is the key to sustaining economic growth– The law of diminishing returns to capital– Solow economic model

• Endogenous growth theory – Technological change is not random but determined by factors in

the market system.– The principle that marginal cost equals marginal revenue in profit

maximization applies in the determination of the amount of knowledge investment firms would like to make.

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Technology and Economic Growth

• New technology affects economy in the way that it enables any given number of workers to produce more output. – Production function shifts upward.

• Government policies that encourage investment in technology– Protecting intellectual property rights– Subsidizing research and development– Subsidizing education

• Entrepreneurship