Economic Growth and Rising Living Standards Overview

Topic 4 Economic Growth and Rising Living Standards 1

Benefits of Growth In the late 18th and early 19th century Life expectancy was 40 years Most families had 2 or 3 children die Nothing moved faster than the speed of a horse The best highway was from Boston to New York A stagecoach made the 175-mile trip in 3 days Pace of technical change is accelerating Inventions are not sufficient to create growth Products must be commercialized and sold 2

Living Standards Use an economic model to study the remarkable rise in living standards Real GDP per person is a measure of the goods available to a typical person One clue to growing prosperity in the 20th century GDP per person in 2010 was 12 times greater than it was in 1870 Comparisons across long periods are complicated by lack of data The variety, quantity, and quality of goods increased enormously in the 19th and 20th century 3

Real GDP per Person, 1870-2010 (in US $) 4

Real GDP per Capita, 1870 - 2010 5

Growth of Real GDP per Capita, 1870 - 2003 6

Arithmetic of Growth: Rule of 72 Approximate number of years required to double real GDP 72 = annual percentage rate of growth

Economic Growth What determines the potential output? Labor productivity or Productivity Amount of output average worker can produce in an hour Average hours of labor Number of hours average worker spends at the job Labor force participation rate (LFPR) Fraction of population that wants to work Size of population 8

What Determines the Potential Output? Labor productivity Total real output = Output per hour Total hours of labor 9

What Determines the Potential Output? Average hours of labor Total hours of labor = Average hours Labor force 10

What Determines the Potential Output? Labor force participation rate (LFPR) Labor force LFPR = Population 11

What Determines the Potential Output? Breaking down the total output Total output Total hours of labor Labor force = Population Total output Total hours of labor Labor Average force Population Labor = Population LFPR Total output productivi ty hours 12

What Determines the Potential Output? Review of some linear algebra If Z = X Y, then % Z % X + % Y If Z = X / Y, then % Z % X - % Y Note: % means percentage change. Applying this rule to the equation of total output 13

Economic Growth What matters for a rising standard of living is real GDP per capita (i.e. per person) Since - Total output = Productivity x Average Hours x LFPR x Population Then - Output per capita = Total output Population Output per capita = Productivity x Average Hours x LFPR In terms of percentage growth rates % Productivi % + Average % + LFPR % Output per capita ty hours 14

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 % Output per person % productivity + % LFPR 15

Growth in the Labor Force Participation Rate (LFPR) Recall that Labor Force LFPR = Population force Labor LFPR % Population So, % - % 16

Growth in the Labor Force Participation Rate (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 % LFPR % Labor force - % 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 17

Figure 1: An Increase in Labor Supply 18

Figure 2: An Increase in Labor Demand 19

Figure 3: The U.S. Labor Market Over A Century 20

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 21

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 22

Growth in Productivity Recently, virtually all growth in the average standard of living can be attributed to growth in productivity What can we do to make productivity grow? 23

Determinants of Average Labor Productivity U.S. average labor productivity is 24 times that of Indonesia 100 times that of Bangladesh Six factors determine average labor productivity 1.Human capital 2.Physical capital 3.Land and other natural resources 4.Technology 5.Entrepreneurship and management 6.Political and legal environment 24

Figure 4: Capital Accumulation and Labor Productivity 25

Growth in the Capital Stock 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 Total capital stock = capital per worker Since , Labor force capital % = per worker % Total capital stock - % Labor force 26

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 Planned 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 27

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 28

Figure 5: An Increase In Investment Spending 29

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 30

Figure 6: An Increase In Savings 31

Governments Budget Deficit A increase in government purchases tends to raise interest rates High interest rates discourage business investments 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 32

Figure 7: Deficit Reduction and Investment Spending 33

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 34

Technology and Economic Growth Another source of growth is technological change Invention or discovery of new inputs, new outputs, or new methods of production New technology affects economy in much the same way as do increases in capital stock Shifts production function upward Since it enables any given number of workers to produce more output Investments in technology R&D 35

Accounting for Growth Factors affecting productivity growth Technological advance (40%) Quantity of capital (30%) Education and training (15%) Economies of scale and resource allocation (15%)

Productivity Puzzle U.S. labor productivity grew 2.8% from 1947 1973 Slowed to 1.4% from 1973 1995 Resurgence to 2.6% between 1995 2010 Slow-down remains a mystery Since 2010, remains to be seen if this is a temporary effect of the last recession or the beginning of a new period of productivity slowdown. Growth since 1995 is largely attributed to information and communications technologies making workers more productive Growth seen in industries that produce these technologies and industries that use them Slower growth in sectors that do not use these technologies 37

Promoting Economic Growth in Least Developed Prescription for more human and physical capital is broadly correct Appropriate technology and education Most countries need institutions to support growth Corruption creates uncertainty about property rights and drains financial resources out of the country Regulation discourages entrepreneurship Taxes discourage risk-taking Markets do not function efficiently Lack of political stability discourages foreign investment 38

Costs of Economic Growth Is economic growth desirable and sustainable? The antigrowth view Environmental and resource issues In defense of economic growth Higher standard of living Human imagination can solve environmental and resource issues

Benefits of Economic Growth Growth is the path to greater material abundance Results in higher standards of living Increases leisure time Allows for the expansion and application of human knowledge Global Competitiveness: http://en.wikipedia.org/wiki/Global_Competitiveness_ Report#2011.E2.80.932012_rankings

Economic Growth in China Four great inventions of ancient China Paper Printing Economic stagnation followed Social system limited entrepreneurship Emperor retained property rights to business Seizure possible without notice Scientific advances alone do not ensure technical change and growth Gunpowder Compass 41

Economic Growth in China Growth averages in the past 25 years: 9% annual growth output 8% annual growth output per capita Labor more productive More international trade Transition to market economy Joined WTO 2001 Financial system remains weak Income inequality across areas