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Chapter 15
How Economies Grow
Copyright © 2005 Pearson Addison-Wesley. All rights reserved. 15-2
Economic Growth
• Earlier you learned that the growth in real GDP is often called economic growth.
• However, when a nation grows economically, its citizens must be better off in at least some ways, usually in terms of their material well-being.
Copyright © 2005 Pearson Addison-Wesley. All rights reserved. 15-3
Economic Growth (cont.)
• Economic growth occurs when there are increases in per-capita output per unit time period, usually per year. Economic growth is measured by the annual rate of change in per-capita real GDP.
Copyright © 2005 Pearson Addison-Wesley. All rights reserved. 15-4
International Example
• India has a total national output that is three times as large as that of Switzerland.
• India’s population, though, is 125 times greater than that of Switzerland.
• Thus, when we take into account the amount of output that is available to the average person, we can conclude that India is a relatively poor country and Switzerland is a relatively rich country.
Copyright © 2005 Pearson Addison-Wesley. All rights reserved. 15-5
Economic Growth and the Magic of Compounding
• Some countries grow and others do not. You can see this in Table 15-1, next.
• There you see the annual average rate of economic growth in selected countries.
Copyright © 2005 Pearson Addison-Wesley. All rights reserved. 15-6
Table 15-1: Per Capita Growth Rates in Various Countries
Copyright © 2005 Pearson Addison-Wesley. All rights reserved. 15-7
Small Differences in Growth Matter
• A small difference in the rate of economic growth may not matter for next year or the year after, but it surely does matter over longer periods.
• It all has to do with the power of compounding.
• The difference of one percentage point in our economic rate of growth over this nation’s history could have lead to three times our current standard of living.
Copyright © 2005 Pearson Addison-Wesley. All rights reserved. 15-8
Compounding Example
• In 1626, Dutchman Peter Minuit arrived in Manhattan, charged by the West India Company with the task of administering the struggling colony.
• Minuit purchased Manhattan Island from Native American Indians for the now legendary price of 60 guilders, or about $20. That $20 compounded at 6 percent would equal about $130 billion today, and at 7 percent about $5.8 trillion today.
Copyright © 2005 Pearson Addison-Wesley. All rights reserved. 15-9
Saving: An Important Determinant of Economic Growth
• Economic growth does not occur in a vacuum. It is not some predetermined fate of a nation.
• Rather, economic growth depends on certain fundamental factors. One of the most important factors that affect the rate of economic growth and hence long-term living standards is the rate of saving.
Copyright © 2005 Pearson Addison-Wesley. All rights reserved. 15-10
A Basic Economic Growth Proposition
• To have more consumption in the future, you have to consume less today and save the difference between your consumption and your after-tax income.
• On a national basis, this implies that higher saving rates eventually mean higher living standards in the long run, all other things held constant.
Copyright © 2005 Pearson Addison-Wesley. All rights reserved. 15-11
A Basic Economic Growth Proposition (cont.)
• Saving is important for economic growth because if all income is consumed each year, there is nothing leftover for saving, which could be used by businesses for investment.
• If there is no investment in our capital stock, there is little hope of economic growth.
Copyright © 2005 Pearson Addison-Wesley. All rights reserved. 15-12
A Basic Economic Growth Proposition (cont.)
• Data shows that in general, nations that have experienced high rates of saving have had greater economic growth rates than those that have not.
Copyright © 2005 Pearson Addison-Wesley. All rights reserved. 15-13
Productivity Increases—It’s What Economic Growth Is All About
• Labor productivity is normally measured by dividing real GDP by the number of workers or the number of labor hours.
Copyright © 2005 Pearson Addison-Wesley. All rights reserved. 15-14
Productivity Increases—It’s What Economic Growth Is All About (cont.)
• Whenever average output produced per worker during a specified time period increases, we say that labor productivity has increased.
• Clearly, there is a positive relationship between economic growth and increases in labor productivity.
Copyright © 2005 Pearson Addison-Wesley. All rights reserved. 15-15
Separating Different Rates of Growth of Production Inputs
• If you divide all resources into just capital and labor, economic growth can be defined as the cumulative contribution to per capita real GDP growth of three components: – the rate of growth of capital,
– the rate of growth of labor, and
– the rates of growth of capital and labor productivity.
Copyright © 2005 Pearson Addison-Wesley. All rights reserved. 15-16
Growth in Technology
• Technology has grown erratically in the United States and elsewhere. Nonetheless, there are some startling statistics about the growth in technology.
• The greater the reward to those who innovate, the more technological advances we will get.
Copyright © 2005 Pearson Addison-Wesley. All rights reserved. 15-17
Growth in Technology: An Example
• Microprocessor speeds currently exceed 3,000 megahertz. By the year 2011, they will exceed 12,000 megahertz.
• During the same period, the size of the thinnest circuit line within a transistor will decrease by 80 percent.
• By 2011, microchip plants will produce 1,500 chips a week for every person on earth
Copyright © 2005 Pearson Addison-Wesley. All rights reserved. 15-18
Research and Development
• A certain amount of technological advance results from research and development (R&D) activities that have as their goal the development of specific new materials, new products, and new machines.
• How much spending a nation devotes to R&D can have an impact on its long-term economic growth.
Copyright © 2005 Pearson Addison-Wesley. All rights reserved. 15-19
Innovation and Knowledge
• Innovation involves the transformation of something new, such as an invention, into something that benefits the economy either by lowering production costs or by providing new goods and services.
• Historically, technologies have moved relatively slowly from invention to innovation to widespread use.
Copyright © 2005 Pearson Addison-Wesley. All rights reserved. 15-20
The Importance of Human Capital
• Knowledge, ideas, and productivity are all tied together. One of the threads is the quality of the labor force.
• Increases in the productivity of the labor force depend on increases in human capital.
• Human capital is the knowledge and skills that people in the workforce acquire through education, on-the-job training, and self-teaching.
Copyright © 2005 Pearson Addison-Wesley. All rights reserved. 15-21
How You Can Invest in Human Capital
• To increase your own human capital, you have to invest by not working for pay while you attend school.
• Society also has to invest in libraries and teachers.
• According to modern economic growth theorists, human capital is at least as important as physical capital, particularly when trying to explain international differences in living standards.
Copyright © 2005 Pearson Addison-Wesley. All rights reserved. 15-22
Schooling is Important
• Researchers have found that one of the most effective ways that developing countries can become developed is by investing in secondary schooling.
• Teaching more children ages 12 to 18 may be more important than having a large network of colleges and universities in developing countries.
Copyright © 2005 Pearson Addison-Wesley. All rights reserved. 15-23
Property Rights and Entrepreneurship
• If you lived in a country where bank accounts and businesses were periodically expropriated by the government, how willing would you be to leave your money in a savings account or to invest in a business?
• You would be living in a political and economic system in which your property rights are not well defined and legally supported.
Copyright © 2005 Pearson Addison-Wesley. All rights reserved. 15-24
Property Rights and Entrepreneurship (cont.)
• The more certain property rights are, the more capital accumulation level will be, and therefore there will be greater economic growth.
• Well defined property rights have usually been necessary for economic growth to occur.
• Entrepreneurs will not take risks if they believe that their rewards from taking risks will be confiscated.
Copyright © 2005 Pearson Addison-Wesley. All rights reserved. 15-25
Key Terms and Concepts
• compounding
• economic growth
• human capital
• innovation
• labor productivity
• nationalization
• property rights
• research and development (R&D)