Chapter 7

Economic Growth: Theory and Policy

Three Pillars of Productivity Growth

Growth policy ensuring that the economy sustains a high long-run growth of Potential GDP Stabilization policy
Keep actual GDP
Close to potential GDP - short run

No high unemployment
No high inflation

Three Pillars of Productivity Growth

Labor productivity grows:

Larger capital stock
Given technology & labor force

Better technology
Given capital & labor

Workforce quality
More education & training
Given capital, technology, labor force

Human capital (education & training)

Amount of skill workforce
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Figure 1
Production functions corresponding to three different capital stocks
c Yc K3 K2

b
Output Yb a Ya

K1

L1 Hours of Labor Input

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Levels, Growth Rates, & Convergence

Level of productivity
Higher in rich countries Depends on
Supply of human & physical capital State of technology

Growth rate of productivity

Depends on growth rates of
Capital Workforce skills Technology
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Table 1
Productivity levels and productivity growth rates in selected countries
Country United States France United Kingdom Spain Ireland Argentina Mexico Brazil South Korea GDP per hour of work 1980 (as percentage of U.S.) 100 86 71 62 57 51 44 33 20 GDP per hour of work 2005 (as percentage of U.S.) 100 99 85 62 96 37 25 23 48 Growth rate 1.7 2.3 2.4 1.7 3.9 0.4 -0.5 0.2 5.4

Levels, Growth Rates, & Convergence

Convergence hypothesis
Nations with current low levels of productivity
At times have higher productivity growth

rates

International productivity differences

Shrink over time

Productivity growth rates of poorer countries tend to be higher tend to be higher than those of richer countries.
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Figure 2
The Convergence Hypothesis
Richer country

Real GDP per capita

Poorer country
$10,000

$2,000

Time
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Levels, Growth Rates, & Convergence

In the long run, low productivity countries should be able to learn from high productivity countries as scientific and managerial know-how spreads around the world. Technological laggards Can close the income gap Imitation, not innovation Existing technologies Convergence club Productivity growth rates - higher Where productivity levels are lower Poorest nations Unable to join due to their inability to adopt advanced technology

Table 2
Levels and growth rates of GDP per capita in selected poor countries
Country Belarus Russia Ukraine Peru Haiti Burundi Sierra Leone GDP per capita 2005* $1,868 2,445 960 2,337 434 105 218 GDP per capita growth rate, 1990-2005 2.0% -0.4 -2.4 2.3 -2.4 -2.5 -0.9

*in constant 2000 U.S. dollars

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Growth Policy: Capital Formation

Nations capital
Available supply
Plant, equipment, software

Result of past decisions investments

Investment
Flow of resources
Production of new capital

Inputs
Construction of capital

Period of time

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Growth Policy: Capital Formation

Capital formation
Investment Process of building up capital stock

Trade-off
More capital formation
Quicker growth

Consume less today

More consumption today

Less capital formation Slower growth
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Figure 3
Choosing between investment and consumption
Investment Goods Produced

A
I

D 0 Consumer Goods Produced

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Growth Policy: Capital Formation

Speed up capital formation / investment

Lower real interest rates Amount that businesses invest depends on the real interest rate they pay to borrow funds. The lower the real rate of interest, the higher would be the investment. Tax provisions Tax laws gives the Government several ways to influence business spending on investment goods. Technical change Invention of mobiles
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Growth Policy: Capital Formation

Speed up capital formation / investment

Growth of demand- High level of sales and expectations of rapid economic growth create an atmosphere conducive to investment. Political stability Property rights
Laws and/or conventions Owners - rights to use their property
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Table 3
Selected countries ranked by level of investor protection
Country Singapore United States Canada United Kingdom Japan Mexico India Sweden Brazil Italy China Swaziland Rating (0-10 scale) 9.3 8.3 8.3 8.0 7.0 6.0 6.0 5.7 5.3 5.0 5.0 2.3

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Growth Policy: Education & Training

More-educated & better-trained workers

Higher productivity Higher wages

Education policy
Improve quality of education

Earning gap
High school graduates College graduates

On-the-job-training
Skills acquired at work
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Growth Policy: Technological Change

Advancement of technology
More education
Scientific, engineering, managerial

More capital formation Research & development (R&D)

Inventing new products/processes

Improving existing ones

R&D encouraged by government

Tax credit Collaborative research Spending on R&D

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Productivity Slowdown & Speed-up, U.S.

1948-1973: 2.8% 1973-1995 Productivity slowdown, 1.4% Productivity slowdown can be due to:
Lagging investment High energy prices Inadequate workforce skills Not: technological slowdown

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Figure 5
Average productivity growth rates in the United States, 19482007

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Productivity Speed-up
Productivity speed-up could be due to:
Education IT revolution Surging investment Falling energy prices Advances in information technology

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Growth in the Developing Countries

Poorly endowed with capital

Difficult to accumulate capital

Development assistance foreign aid

Outright grants & Low-interest loans From rich countries & multinational institutions To spur economic development

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Growth in the Developing Countries

Foreign direct investment

Purchase/construction
Real business assets

Multinational corporations

Low level of technology Low levels of education & training Poor geographical conditions Poor health Governance
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Table 4
Average educational attainment in selected countries, 2000
United States Canada South Korea Japan United Kingdom Italy Mexico India Brazil Sudan 12.3 11.4 10.5 9.7 9.4 7.0 6.7 4.8 4.6 1.9

For people older than 25 years of age

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From the Long Run to the Short Run

Over long periods of time

Similar growth rates
Actual GDP Potential GDP

Macroeconomic fluctuations
GDP shrinks recessions

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