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Flashcards in Long Run Economic Growth Deck (13):
1

Economic Growth?

Rule of 72?

Small differences in annual growth rate?

Economic growth is sustained, long-run increases in the level of real GDP
- shifting of Y*

Rule of 72 tells us the # of years it takes to double GDP

72/growth rate (not as decimal) = # of years to double GDP

Small differences in income growth rates make enormous differences in real GDP
(ex: 1% versus 2%)
- because real GDP gets compounded

2

Three economic variables

1) Real GDP

2) Real GDP per capita

3) Real GDP per worker (productivity)

Real GDP > real GDP per capita > real GDP per worker

3

Benefits of Economic Growth

(average material living standards are typically measured with real per capita GDP)

1) Rising Average Material Living Standards
- changes society's consumption patterns from tangible goods toward services
- also lead to a demand for a cleaner environment

2) Addressing Poverty and Income Inequality
- with economic growth, it is more possible to redistribute some INCREMENT/gain in income, thereby reducing income inequalities while simultaneously allowing all incomes to rise

4

Costs of Economic Growth

Economic production leads to Environmental damage

Other costs include:
1) Forgone Consumption
- sacrifice of current consumption today will lead to economic growth in the future
- increase in saving rate will lead to a decrease in SR national income, but a higher economic growth in LR

2) Social Costs
- when existing firms, products and skills become obsolete with growth
- but many people who suffer from this the most (lost jobs and lowered incomes) share the least benefits of economic growth

5

**Sources of Economic Growth

4 Determinants

1) Growth in Labour Force
- increase in population
- increase in labour force (more people looking for work)

Occurs when:
- personal income tax rate falls (stimulates people to join labour force)

2) Growth in human capital = skills of workers acquired through formal education and training
- quality of labour force

Occurs when:
- government spending on education

3) Growth in physical capital
- stock of physical capital include: factories, machines, electronic equipment, and transportation and communications facilities
- growth only through investment
- improvements in quality of physical capital

4) Technological improvements
- innovation that introduces new products, new ways of producing existing products, and new forms of organizing economic activity

*Different theories of economic growth emphasize different sources of growth

Productivity can be increased via:
- infrastructure
- health

6

Long run analysis

Without government

With government

National Saving?

Relationship with interest rate?

Recall SR macro model without government and trade. Equilibrium was...

Y = C + I
Y - C = I
Savings = Investment

In LR, real GDP = Y* and the interest rate adjusts to determine equilibrium (IR is endogenous)

Add the government: government purchases (G) and net tax revenues (T)

Private Saving = Y* - T - C

Public Saving (surpluses after spending) = T - G

National Saving = Private + Public Saving

NS = Y* - C - G

- NS is negatively related to consumption and government purchases
- NS is positively related to interest rate

As interest rate increases, more people would rather save then invest/spend (borrow)

7

Market for Financial Capital

(LR version of macro model, with real GDP = Y*)

Y axis: Real Interest Rate

X axis: Quantity of Investment and Saving ($)

Upward sloping NS curve (supply of savings)
- from households and governments

Downward sloping Investment curve (demand for investment)
- from firms

Equilibrium Interest rate (i*) is where Desired NS = Desired I

*Changing i* will be a movement!

8

Shifts in NS and I

Effect on Y*?

An INCREASE in NS causes NS to shift right
- could happen because Consumption DECREASE, government purchases DECREASE, tax revenue increases (WHICH REDUCES C)
- Real Interest falls
- investment increases
- higher investment = higher future growth rate of potential output
(movement along I curve)

An increase in Investment demand causes I to shift right
- could happen because technological improvements (increase productivity of investment goods), government tax incentives aimed at encouraging investment
- real interest rate increases
- household SAVINGS INCREASE (increase in Q of I and S)
- higher rate of saving and higher investment = higher future growth rate of potential output
(movement along NS curve)

9

Relationship between investment rates and growth rates

Positive relationship between investment rates and economic growth

10

Neoclassical Growth Theory

Assumptions of the Aggregate Production Function

Four sources of economic growth are connected by the Aggregate Production Function
- shows the relationship between the total amount of each factor of production employed and total GDP

GDP = FT(L, K, H)

- FT means the function depends on state of tech (keep this constant when comparing L, K, and H)
- similarly, for given values of L, K, and H (constant), changes in T will lead to changes in GDP

(for simplicity, K and H are combined into single variable called capital)

Assume...

1) Diminishing Marginal Returns of K and L
- when only ONE of the factors increases, Y increases at a decreasing rate
- marginal product and average product are DECREASING
- "too many cooks in the kitchen"

(must hold the other factor constant!)
- can use partial derivatives

2) Constant Returns to Scale
- when ALL factors increase together by the same proportion, Y increases by the same proportion

Ex: if L and K increase by 10% each, output will change by 10% too

11

Economic Growth in the Neoclassical Model related to sources of economic growth

Solow Residual

1) Labour-force growth
- due to law of diminishing marginal returns, increases in population (with fixed stock of capital) will increase GDP, but lead to an eventual DECLINE in material living standards
- therefore will increase GDP, but lead to eventual DECREASE in per capita GDP

2) Physical and Human Capital Accumulation
- capital accumulation lead to improvements in material living standards, but because of the law of diminishing returns, these improvements will become smaller with each additional increment of capital
- With constant returns to scale, balanced growth (increase in K and L by same rate) will cause GDP to grow, but GDP per capita will remain CONSTANT

3) Technological change
- exogenous technology
- only way to get improvements in living standards

Solow Residual: the amount of GROWTH in GDP that CANNOT be accounted for by observed growth in the labour force and capital stock
- residual was interpreted as a measure of TECHNICAL change
- given other name: the rate of growth of total factor productivity (TFP)

12

Newer Growth Theories

Endogenous Technological change

Increasing marginal returns

Endogenous Technological change:
- Growth is achieved through costly, risky, innovative activity that often occurs in response to economic signals (i.e. changes in relative prices)

- learning by doing
- knowledge transfer via experience
- market structure and innovation (increased competition leads to more innovation)
- shocks and innovation (shocks can lead to a wave of innovations

Increasing Marginal Returns:
- caused by investment in capital
- due to market-development costs or knowledge

(new innovation will cause followers, leading to increasing marginal returns)
- the returns to investment LATER are greater than the returns to the same investment made earlier
- economic environment becomes more fully developed over time

- also knowledge provides the input that allows investment to produce increasing rather than diminishing marginal returns

13

Are there limits to growth?

1) Resource exhaustion:
- many people are consuming increasing quantities of resources
- world's current resources and present capacity to cope with pollution and environmental degradation are INSUFFICIENT to accomplish this rise in global living standards
- HOWEVER, absolute limits to growth are NOT RELEVANT. This is because technology continually changes and discoveries. There is also resource efficiency

2) Environmental Degradation
- due to pollution
- concerns about environmental sustainability