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

2

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

3

Production functions corresponding to three different capital stocks

Figure 1

4

0

Hours of Labor Input

Out

put

L1

Ya

K1

Yb

Yc

K2

K3c

b

a

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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Productivity levels and productivity growth rates in selected countries

Table 1

6

CountryGDP per hour of work 1980

(as percentage of U.S.)GDP per hour of work 2005

(as percentage of U.S.)Growth

rate

United StatesFranceUnited KingdomSpainIrelandArgentinaMexicoBrazilSouth Korea

1008671625751443320

1009985629637252348

1.72.32.41.73.90.4-0.50.25.4

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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The Convergence Hypothesis

Figure 2

8

0Time

Rea

l GD

P p

er c

apita

$2,000

Poorer country

$10,000

Richer country

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

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Levels and growth rates of GDP per capita in selected poor countries

Table 2

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Country GDP per capita 2005*

GDP per capita growth rate, 1990-2005

BelarusRussiaUkrainePeruHaitiBurundiSierra Leone

$1,8682,445960

2,337434105218

2.0%-0.4-2.42.3-2.4-2.5-0.9

*in constant 2000 U.S. dollars

Growth Policy: Capital Formation

• Nation’s 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 time11

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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Choosing between investment and consumption

Figure 3

13

0Consumer Goods Produced

Inve

stm

ent

Goo

ds P

rodu

ced

D

C

I

A

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 mobiles14

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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Selected countries ranked by level of investor protection

Table 3

16

Country Rating (0-10 scale)

SingaporeUnited StatesCanadaUnited KingdomJapanMexicoIndiaSwedenBrazilItalyChinaSwaziland

9.38.38.38.07.06.06.05.75.35.05.02.3

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 17

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 18

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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Average productivity growth rates in the United States, 1948–2007

Figure 5

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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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Average educational attainment in selected countries, 2000

Table 4

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United StatesCanadaSouth KoreaJapanUnited KingdomItalyMexicoIndiaBrazilSudan

12.311.410.59.79.47.06.74.84.61.9

For people older than 25 years of age

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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