1 of 18

Recall from last time…

1. Economists think differently about short-run and long-run

changes in macroeconomic variables.

2. Any change in real GDP can be decomposed into changes

in factor supply, the utilization rate of factors, and
productivity.
 2 of 18

Recall from last time …

3. Short-run changes in GDP are mostly caused by changes

in factor utilization, whereas long-run changes in GDP are
mostly caused by changes in factor supplies and
productivity.

4. Macroeconomic policies will only have a long-run effect on

output if they influence factor supplies or productivity.
Three Sources of Changes in GDP
 4 of 18

Policy Implications of GDP decomposition

Fiscal and monetary policies affect the short-run level of GDP

because they alter the level of aggregate demand.

But unless they are able to affect the level of potential output,
they will have no effect on long-run GDP.

- broad consensus that monetary policy has

only limited effects on Y*
- fiscal policy probably has more effects on Y*
 5

Long-Run Economic
Growth
 6

In this lesson you will learn...

1. …about the costs and benefits of economic growth.

2. …the four fundamental determinants of growth in real GDP.

3. …the main elements of Neoclassical growth theoryin

which technological change is exogenous.

4. …about new growth theories based on endogenous

technical change and increasing returns.

5. …why resource exhaustion and environmental degradation

create serious challenges for public policy directed at
sustaining economic growth.
 7

The Nature of Economic Growth

Sustained increases in Y* are more powerful method of

raising material living standards than the removal of
recessionary gaps.

Even small differences in annual growth rates can result in

large changes in living standards after many years.

Consider GDP, per capita GDP, and GDP per worker.

 Three Aspects of Economic Growth

These three economic variables show different aspects of economic growth. Each
variable is expressed as an index number.
 Rule of 70

• Sustained growth causes huge changes

in living standards
• The Rule of 70 states that the number of
years it takes for the level of a variable to
double is approximately 70 divided by the
annual percentage growth rate of the
variable.
 More Rule of 70
• Using the Rule of 70
–A variable that grows
at 7 percent a year
doubles in 10 years.
–A variable that grows
at 2 percent a year
doubles in 35 years.
–A variable that grows
at 1 percent a year
doubles in 70 years.
 12

Benefits of Economic Growth

• Rising Average Living Standards

•Economic growth is a powerful means of improving average

material living standards.

•Economic growth that raises average income tends to

change the whole society’s consumption patterns, shifting
away from tangible goods toward services.

•Economic growth provides the higher incomes that often lead

to a demand for a cleaner environment.
Benefits of Economic Growth
• Addressing Poverty and Income Inequality

In recent years, the majority of aggregate income growth in

many countries, including Canada, has been accruing to
the top earners in the income distribution.
The result is that, while average per capital incomes have
been rising, there has also been a rise in income inequality
and a relative stagnation of incomes for those at or below
the middle of the income distribution.
Poverty and income inequality are important challenges for
public policy.
- but redistribution is easier in a growing economy
 14

An Open Letter from a Supporter of

the “Growth Is Good” School:
what should it contain?
 15

Costs of Economic Growth

Forgone Consumption
In a world of scarcity, almost nothing is free, including
economic growth.
Economic growth, which promises more goods and
services tomorrow, is achieved by consuming fewer
goods today.
This sacrifice of current consumption is an important
cost of economic growth.
16
Social Costs
•Part of growth is accounted for by existing firms expanding and
producing more output, hiring more workers, and using more
equipment and intermediate goods.

•But another aspect of growth is that existing firms are overtaken

and made obsolete by new firms, old products are made obsolete
by new products, and existing skills are made obsolete by new
skills.

•It is often argued that costs of this kind are a small price to pay for
the great benefits that growth can bring.

•But many of the people for whom growth is most costly (in terms of
lost jobs or lowered incomes) share least in the fruits that growth
brings.
 18

An Open Letter from a Supporter of

the “Growth Is Bad” School :
What should it contain?
 19

Environmental Efficiency of Supporting Well-Being: Happy Planet Index (2013)

www.myeconlab.com
 20

Sources of Economic Growth

The four fundamental sources of economic growth are:

1. Growth in the labour force.

2. Growth in human capital.
3. Growth in physical capital.
4. Technological improvement.

Different theories emphasize different sources of growth.

 22

Established Theories of Economic Growth

Focus on the Long Run
In the simplest short-run macro model (with no government
or foreign trade), the equilibrium level of real GDP is such
that real GDP equals desired consumption plus desired
investment:
Y=C+I
Y – C = I or S = I

In the short-run, real GDP adjusts to determine equilibrium,

in which desired saving equals desired investment.

In the model’s long-run version, real GDP is equal to Y* and

the interest rate adjusts to determine equilibrium.
 23

Investment, Saving, and Growth (in a closed economy)

We now complicate our model by adding a government sector

that purchases goods and services (G) and collects taxes net
of transfers (T).

Our model has two parts:

Investment — increases in the stock of capital — lead to
increases in the future level of Y*.

Saving by households (and firms) is used to finance this

investment.
 interest rate is the “price” that equilibrates this
market
 24

Investment, Saving, and Growth (in a closed economy)

With real GDP equal to Y* in the long run, desired private

saving is equal to:

Private saving = Y*-T – C

Public saving is equal to the combined budget surpluses of

the federal, provincial, and municipal governments.

Public saving = T – G
 25

•With a government sector added to our model:

– Investment:
•Firms' investment demand is negatively related to
the real interest rate.

– Saving:
•National saving is positively related to the interest
rate.
 26

Firms’ investment demand is negatively related to the real

interest rate.

National saving = private saving + public saving

 NS = Y* - T - C + (T - G)
 NS = Y* - C - G

If C is negatively related to the interest rate, then NS is

positively related to the interest rate.
 27

• National saving = NS = Y*-T – C + (T – G)

• NS = Y*- C – G

• So for a given level of real GDP in the long run

(Y*), an increase in household consumption or
government purchases implies a reduction in
national saving.

• The supply curve for national saving and the

investment demand curve make up the economy’s
market for financial capital.
 28

NS = Y*-C-G With Y = Y*, the

Excess
Supply condition that desired
national saving equals
i1 • • desired investment
i* • E
determines the
i2 • • I equilibrium interest
Excess
Demand
rate.
I*=NS* Loanable Funds

At point E, the market for loanable funds clears and the

equilibrium real interest rate is i*.
 29

Investment demand by
NS = Y*-C-G firms is negatively
Excess related to the real
Supply
interest rate.
i1 • •
The supply of national
i* • E
saving is positively
i2 • • I related to the real
Excess
Demand interest rate.
I*=NS* Loanable Funds
In the long run, with real
GDP equal to Y*, the
equilibrium interest rate
is determined where
desired national saving
equals desired
investment
 30

Suppose the supply of national saving increases:

 the NS curve shifts to the right

Increased national saving

reduces the real interest
rate and encourages more
NS0
investment.
NS1

E0
i0*
• E1
Greater flow of investment
i1* • I
leads to a higher growth rate
of potential output.

I0* I1* Loanable Funds

 31

Now suppose that investment demand increases

 the I curve shifts to the right

In the long run, increased

investment demand
pushes up the interest rate
NS and encourages more
saving by households.

i1* • E1
Greater flow of saving (and
i0*
E0
• I1
investment) leads to a
I0 higher growth rate of Y*.

I0* I1* Loanable Funds

 32

Empirically, countries with high investment rates also

have high growth rates, as predicted by the model.
 33

Neoclassical Growth Theory

This theory begins with the idea of an aggregate production
function: the relationship between the total amount of each
factor of production employed and total GDP.

GDP = FT(L,K,H)

- L is the total amount of labour

- K is the stock of physical capital
- H is the quality of human capital
- T is the state of technology

The notation FT reflects the assumption that changes in

technology will change the production function.
 34

The Causes of Economic Growth: A First Look :

Limits of economics. The major obstacles to growth are
political, and economists don’t know much about how to
remove those political obstacles. See e.g., Kabul, Mogadishu,
and other troubled cities in which the rule of law has
completely broken down.

Economists know a lot about how to make an economy grow

if the preconditions are in place, but virtually nothing about
how to bring those preconditions about.
 35

The Causes of Economic Growth: A First Look :

The three preconditions for growth—markets, property rights,

and monetary exchange—are all essential to create
acceptable levels of risk and low enough transaction costs to
justify investment, specialization, and exchange.

Question: is what matters the particular system of property

rights, or just that they be clear, certain, and enforceable with
reasonable cost—the concept of the rule of law.
{Property rights are highly varied, and many fast growing
economies have nothing like Canada’s absolute property
rights in land, for example.}
 36

The key assumptions about the aggregate production function

are:

1. Diminishing marginal product of both K and L

- when either factor is changed in isolation

2. Constant returns to scale

- when both K and L are changed in equal proportions

For simplicity, we will assume that human capital and

physical capital can be combined into a single variable
called capital and that technology is held constant.
 37

• The law of diminishing marginal returns is the

hypothesis that if increasing quantities of a
variable factor are applied to a given quantity of
fixed factors, the marginal product of the variable
factor will eventually decrease.

• Constant returns to scale is a situation in which

output increases in proportion to the change in all
inputs as the scale of production is increased.
 38

40 Total
L Units of APL MPL • Output
35 •

Units of Output
Output
1 12.0 12.0 30 •
2 17.0 8.5 5.0 25 •
3 20.8 6.9 3.8 20
•
4 24.0 6.0 3.2 15
5 26.8 5.4 2.8 10
6 29.4 4.9 2.6 2 4 6 8 10
7 31.9 4.6 2.5 Units of Labour
8 34.0 4.2 2.1
9 36.0 4.0 2.0 Holding K constant, increases in L
10 37.9 3.8 1.9
generate positive but diminishing
increments to output.
 39

What are the central predictions for this model?

1. Labour-Force Growth

According to the law of diminishing returns, the MP of L

eventually falls as each successive unit of L is used (for a
fixed amount of other factors).

 increases in population lead to increases in GDP

but eventually to reductions in per capita GDP

 falling average living standards (Malthus)

 Effect of Immigration
• Is immigration bad for us?
• So the model says that an increase in
population, ceteris paribus, increases
real GDP but lowers real GDP per
person and lowers the real wage rage
– Does this outcome mean that immigration
is bad for us?
 Is Immigration Bad For Us?
• No!
– Historically, immigrants have brought capital and
entrepreneurship, and been some of the most
creative sources of technological change
– Combining the effects of capital accumulation and
technological change with an increase in
population, real GDP will increase but the change
in the wage rate is ambiguous
– Since, historically, capital accumulation and
technological change have outstripped population
growth, it seems that immigration has been (and
probably continues to be) a positive economic
force
 42

2. Physical and Human Capital Accumulation

Similarly, diminishing MP of K means that capital

accumulation on its own brings smaller and smaller increases
in real per capita GDP.
 43

3. Balanced Growth with Constant Technology

If capital and labour grow at the same rate, GDP will

increase.

But the assumption of constant returns to scale means that if

K and L grow at the same rate there will be no improvements
in material living standards.

 GDP will grow but per capita GDP will be constant.

 44

4. The Importance of Technological Change

In the Neoclassical growth model, technological change is

necessary for sustained growth in living standards.

Much technological change is embodied in new capital

equipment
 investment is crucial

Measuring the extent of technological change is difficult –

because it is not directly observable.
 45

4. The Importance of Technological Change

In Neoclassical growth theory, technological change is

assumed to be exogenous.

This is an important weakness of the theory because it means

that the theory is unable to explain what is undoubtedly the
most important determinant of long-run improvements in living
standards.
 Effect of Labour Productivity
• What is the effect of
an increase in labour
productivity on the
production function?
• The increase in
labour productivity
shifts the production
function upward
 47

Robert Solow (MIT)

- his “growth accounting” method estimates technical

change as the part of growth that is unexplained by
capital accumulation or labour-force growth

 the “Solow Residual”

Should Workers Be Afraid of Technological Change?

• Is new technology necessarily better for

social welfare?
• Potential problem: capital accumulation
and technological change decrease the
demand for the labour that the new
capital replaces
– Which decreases the wage paid to that
labour and may lead to unemployment
 Complementary Labour
• But the decrease in demand for labour is not the only
effect
• There is also an increase in the demand for other
types of labour—complementary labour
• People must acquire more skill—some people learn
to work with the new capital, some learn how to
maintain it in good condition, some learn how to build
it, some learn how to market and sell it, some learn to
design new ways of using it, some work on thinking
up new goods and services to produce with it, and so
on
– All of these people are more productive that they
were before
 A Problem with Neoclassical
Growth Theory
• All economies have access to the same
technologies and capital is free to roam the
globe, seeking the highest available real
interest rate
• These facts imply that economic growth rates
and real GDP per person across economies
will converge.
– But remember that the data show some
convergence among rich countries, but
convergence is slow
 Trends: Real GDP/person

• Gaps between real GDP/person in Canada

and in these poor countries have widened
 Another Neoclassical Problem
• Assumes that the primary engine of
growth (technology) is exogenous
• This is not very helpful as far as policy
recommendations for encouraging
economic growth
 54

New Growth Theories

Endogenous Technological Change

• Research by many scholars has established that

technological change is responsive to such economic
signals as prices and profits; it is endogenous to the
economic system.

• Growth is achieved through costly, risky, innovative activity

that often occurs in response to economic signals.
 55

New Growth Theories

Endogenous Technological Change

New growth theory emphasizes the process of innovation and

the incorporation of new technology:

• learning-by-doing
• knowledge transfer
• market structure and innovation
• shocks and innovation
 56

Increasing Marginal Returns

New growth theories also emphasize the possibility that

each new increment of investment is more productive than
the last.
- contrasts with the Neoclassical assumption of
diminishing marginal returns.

Some research suggests the possibility of increasing

returns that remain for considerable periods of time.

The sources of increasing returns usually fall into one of two

categories:
• market-development costs
• increasing returns to knowledge
 Important Idea
• Knowledge Capital Is Not Subject to
Diminishing Returns
• Increasing the stock of knowledge makes
capital and labour more productive
• Knowledge capital does not experience
diminishing returns is the central
proposition of new growth theory
• Can be used by others without diminishing
its usefulness
 New Growth: Perpetual Motion

• The idea that economic growth is self-

sustaining
• As more knowledge capital is created, it
increases the incentives for the
development of even more knowledge
capital
Growth Theories, Evidence, and Policies
Sorting Out the Theories
Each theory teaches us something of value but not the
whole story.
Classical theory reminds us that our physical resources are
limited and we need technological advances to grow.
Neoclassical theory emphasizes diminishing returns to
capital which means we need technological advances to
grow.
New theory emphasizes the capacity of human resources to
innovate at a pace that offsets diminishing returns.
Growth Theories, Evidence, and Policies
The Empirical Evidence on the Causes of Economic
Growth
Economic growth makes progress through the interplay of
theory and empirical evidence.
Theory makes predictions about what we will observe if it is
correct.
Empirical evidence provides the data for testing the theory.
The table on the next slide summarizes the more robust
influences on growth that economists have discovered.
Growth Theories, Evidence, and Policies
The Empirical Evidence on the Causes of Economic
Growth
Economic growth makes progress through the interplay of
theory and empirical evidence.
Theory makes predictions about what we will observe if it is
correct.
Empirical evidence provides the data for testing the theory.
Then table on the next slide summarizes the more robust
influences on growth that economists have discovered.
Growth Theories, Evidence, and Policies

Policies for Achieving Faster Growth

Growth accounting tell us that to achieve faster economic
growth we must either increase the growth rate of capital
per hour of labour or increase the pace of technological
change.
The main suggestions for achieving these objectives are
Stimulate Saving
Saving finances investment. So higher saving rates might
increase physical capital growth.
Tax incentives might be provided to boost saving.
Growth Theories, Evidence, and Policies

Stimulate Research and Development

Because the fruits of basic research and development

efforts can be used by everyone, not all the benefit of a
discovery falls to the initial discoverer.

So the market might allocate too few resources to research

and development.

Government subsidies and direct funding might stimulate

basic research and development.
Growth Theories, Evidence, and Policies

Improve the Quality of Education

The benefits from education spread beyond the person being
educated, so there is a tendency to under invest in education.
Provide International Aid to Developing Countries
If rich countries give financial aid to developing countries,
investment and growth will increase.
But data on the effect of aid shows that it has had zero or a
negative effect.
Growth Theories, Evidence, and Policies

Encourage International Trade

Free international trade stimulates growth by extracting all

the available gains from specialization and trade.

The fastest growing nations are the ones with the fastest
growing exports and imports.
 67

Are There Limits to Growth?

Resource Exhaustion

• Most everyone in the world today would like to achieve a

standard of living equal to that of the average Canadian
family.

• Unfortunately, the world’s current resources and its present

capacity to cope with pollution and environmental
degradation are insufficient to accomplish this rise in global
living standards with present technology.
 68

Are There Limits to Growth?

Resource Exhaustion
Current technology and resources could not support the entire
world’s population at the average Canadian standard of living.

- but absolute limits to growth may not be relevant

 69

Resource Exhaustion
• Technology changes continually, as do available stocks of
resources.
• Along with advances in technological knowledge typically
comes an increase in the economy’s resource efficiency—a
reduction in the amount of resources used to produce one
unit of output.
• Technology is constantly advancing, and many things that
seemed impossible a generation ago will be commonplace a
generation from now.
• Such technological advance makes any absolute limits to
economic growth less likely.
- but technological improvements are not automatic —
they do not “just happen”
 70

Environmental Degradation

Conscious management of pollution was unnecessary when

the world’s population was one billion people, but such
management has now become a pressing matter.

Conclusion

Growth can help the world address many problems. But

further growth must be sustainable growth, which should be
based on knowledge-driven technological change.