Economic Growth Theory and Policy

8/3/2019 Economic Growth Theory and Policy

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Economic Growth: Theory and

Policy

Macroeconomics

Prof. Rushen Chahal

2/12/2012 Prof. Rushen Chahal


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Today

The three pillars of productivity growth

Convergence hypothesis

Encouraging economic growthThe productivity slow-down and speedup in

America

Why is college so much more expensive todaythan it was 20 years ago?



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Economic Growth

Question: Why does college education keepgetting more expensive?

College tuition rose 674 percent between the

years 1978 and 2003, as compared to a 182

percent rise in overall CPI

We will return to this question later.



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The Three pillars of Productivity

Growth

1. Capital (Physical)

2. Technology

3. Labor Quality (Human Capital)



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Copyright 2004 South-Western

GROWTH IN WORLD REALPER CAPITA GDP

-200

0

200

400

600

800

1000

11th 12th 13th 14th 15th 16th 17th 18th 19th 20th

Growth

inPerCapitaRe

alGDP



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A Review of Capital

Capital is all of the stuff required to produce things

Examples of Capital:

Factories

Roads

Power Plants

Trucks

Computers



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A Review of Capital

Labor input(hours)

RealG

DP

L1

Y0K0

K1

Assume an economy has aproduction function whenthe capital stock is somelow number, K0Suppose labor is constant

and does not grow over time,staying at point L1

At labor L1, total output is atYo, which is equal topotential GDP.

But what if a change in thecapital stock pushes theproduction function up?



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A Review of Capital

Labor input(hours)

RealG

DP

L1

Y0

Y1

K0

K1

An increase in capital stockwill push the productionfunction upNow, with the same amount

of labor input hours, outputis increased to point Y1 dueto the new productionfunction

For a given technologyand labor force, laborproductivity will behigher when the capitalstock is larger



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A Review of Technology

What happens to output when technological

advances are made in a society?



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A Review of Technology

Labor input(hours)

RealGDP

L1

Y0

Y1

PF0

PF1

Here you can see a shiftupwards of the productionfunction, due to

technological improvementin an economy

An improvement intechnology will push theproduction function up,thus increasing outputFor given inputs of laborand capital, laborproductivity will behigher when thetechnology is better



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Technological change that has

benefited the economyThe steam engine

Electricity

Internal Combustion EngineWide Body Jet

Fax Machine

Photocopy Machine



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Technological change that has

benefited the economyThe Telephone

The Radio

The TelevisionThe DVD player

The Computer



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Labor Quality (Human Capital)

Increased Workforce Quality can also increase

output

Which group of people would be better able to

produce computers:

A. 50 laborers with a middle school education

B. 50 laborers with masters degrees in Computer science



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A Review Human Capital

Labor input(hours)

RealGDP

L1

Y0

Y1

PF0

PF1

Here you can see a shiftupwards of the productionfunction, due to an increaseof education and training of

the workforce

An improvement ineducation and training willpush the productionfunction up, thus increasing

outputFor given inputs oftechnology and capital,labor productivity will behigher when the the

workforce has moreeducation and training.2/12/2012 Prof. Rushen Chahal


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The Three Pillars of Productivity

GrowthWhen discussing productivity growth, it is not thecurrent levels of capital (physical), technology and

workforce quality (human capital) that matter, but theirrates of increase.

Wealthy nations have more capital, technology, and

skilled workers than poorer countries

But the growth rates of these inputs are notnecessarily lower in poorer countries



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Country GDP per hourof work 1973(as percentageof U.S. GDP)

GDP per hour ofwork 1998 (aspercentage ofU.S. GDP

GrowthRate

United States 100 100 1.5

France 76 98 2.5

UnitedKingdom

67 79 2.2

Germany 62 77 2.4

Argentina 45 39 0.9

Ireland 41 78 4.1

Mexico 38 29 0.5

Peru 26 15 -0.7

Brazil 24 23 1.2

The U.S. clearly

has a higherGDP per hourof work thanthese othercountries



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GrowthRate


France 76 98 2.5

UnitedKingdom

67 79 2.2

Germany 62 77 2.4

Argentina 45 39 0.9

Ireland 41 78 4.1

Mexico 38 29 0.5

Peru 26 15 -0.7

Brazil 24 23 1.2

But the growth

rate of GDP perhour of workwas higherthan the U.S.for some of

these countriesWhy is this?



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GrowthRate


France 76 98 2.5

UnitedKingdom

67 79 2.2

Germany 62 77 2.4

Argentina 45 39 0.9

Ireland 41 78 4.1

Mexico 38 29 0.5

Peru 26 15 -0.7

Brazil 24 23 1.2

The levels of capitalstock, technology,and education wereprobably lower inthese countries

But the capitalstock, level oftechnology, andaverageeducationalattainment

probably allincreased fasterin thesecountries than inthe United states



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The Three Pillars of Productivity

GrowthThe levelof productivity in a nation dependson its supplies of human and physical capital

and the state of its technology.

But the growth rate of productivity depends on

the rates of increase of these three factors

(Baumol, 2001)



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The Convergence Hypotheses

This hypothesis states that the productivity

growth rates of poorer countries tend to be

higher than those of richer countries, so in the long run the growth

rates will converge (they will become equal).

Time

RealGDP

perCapita

$2,000

$10,000

Richer Country

Poorer Country



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Why might this happen?

In poor countries, the capital stock might be growing fasterthan in rich countries.

The education level might be growing faster as more peoplereceive basic and higher education.

The main reason for this long run convergence is that poorcountries can copy (learn from) rich countries. They donot have to grow through new research and innovation,which is slower and more costly than learning fromsomeone else.



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Innovation: The creation of new technology

and ideas.

The most technologically advanced (rich)

nations depend on research and innovation to

increase technology. This is costly and time

consuming (takes a long time).



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Imitation: Using technologies and ideas

already developed by other nations

to use in your own nation.

Less advanced (poor) countries can use imitation

to adopt technologies already in use by more

advanced (rich) countries



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Does this always happen?

Country GDP per Capita,1999 (In U.S. $)

GDP Growth rate1990-1999

Belarus $2,630 -4.3%

Russia 2,270 -6.1

Ukraine 750 -10.8

Ecuador 1,310 2.2

Haiti 460 -1.7

Cameroon 580 1.3

Rwanda 250 -1.5

Sierra Leone 130 -4.8

Clearly not allpoor countriesexperience this

convergenceprocess



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Growth Policy: Encouraging Productivity

Growth

In order to encourage growth, the government

can take measures to encourage the growth

of:A. Capital (Physical)

B. Technology

C. Workforce Quality (Human Capital)



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Growth Policy: Encouraging Productivity

Growth

We say:

Capital formation (building new physical capital)

Technology development (Technological Progress)

Workforce Quality (Human Capital) Improvement



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Growth Policy: A: Encouraging Capital

Formation

Investment: The purchase of capital by businesses,which will increase the capital stock

Capital Formation: The process through whichbusinesses invest in capital,and thus form new capital

In order to increase the capital stock, governments can dowhat?

They can encourage businesses to invest.

How can they do this?



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Formation

Encouraging Investment:

1. Interest rates

2. Tax laws3. Technical change

4. Growth of demand

5. Political stability and Property Rights



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Formation

1. Interest Rates

Where do businesses get money for investment?

Mainly by borrowing it.

So, when interest rates fall, investment normally

rises. Why?

Because business often borrow to finance their

investments, and the real interest rates is the cost of

borrowing money. When interest rates fall, borrowing

money is less expensive, so investment is less

expensive.



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Formation

1. Interest Rates

Conclusion:

Lower interest rates = less expensive to borrow = more

investment

Higher interest rates = more expensive to borrow = lessinvestment

The government can encourage more investment bylowering interest rates. It can discourage investment by

raising interest rates.



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Formation2. Taxes

Capital gains the profit earned by selling anasset for more than you paid for it.

Taxes on capitalgains - tax on businesses

profits from selling capital.

By decreasing these taxes, government can

encourage businesses to invest more. Taxes oncorporate profits can also be decreased in order to

encourage investment. The government can

encourage investment rates by lowering taxes

on investment.2/12/2012 Prof. Rushen Chahal


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Formation

3. Technology

Technology and capital are closely related. It is often

the case that the only way to use new technology is

to buy new capital.

Therefore when there is new technology available, it

will encourage businesses to investment in new

capital.

Policies that encourage improvement of technology

(to be discussed later) will also encourage investment



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Formation

4. The Growth of Demand

When demand is very high, businesses feel that

increased investment will be profitable.

High levels of sales relative to current capacity

and expectations of rapid economic growth

create an atmosphere conducive to investment

(Baumol, 2001)

Increased government spending or lower taxes (or lowerinterest rates) will increase aggregate demand



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Formation

5. Political Stability and Property Rights

Businesses (and all people) want to be sure that

their property or profits will not be taken fromthem. If they think this will happen, then they

will not invest. This is one reason that

investment in Africa has been so low, but is

now increasing. Property rights are possiblythe most important factor for the creation of

capital.



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The Importance of Investment

Copyright2003 Southwestern/Thomson Learning

(a) Growth Rate 19601991 (b) Investment 19601991

South Korea

Singapore

Japan

Israel

Canada

Brazil

West Germany

Mexico

United Kingdom

Nigeria

United States

IndiaBangladesh

Chile

Rwanda

South Korea

Singapore

Japan

Israel

Canada

Brazil

West Germany

Mexico

United Kingdom

Nigeria

United States

IndiaBangladesh

Chile

Rwanda

Investment (percent of GDP)Growth Rate (percent)0 1 2 3 4 5 6 7 0 10 20 30 40



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Growth Policy: B: Encouraging Technology

Development (Technological Progress)

1. Education

2. Capital Formation

3. Research and Development



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1. Education

Who are the leaders in innovation and

technological progress?a. Scientists

b. Engineers

c. Skilled business managers



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1. Education

High levels of education, especially

scientific, engineering, and managerialeducation, contribute to the advancement

of technology (Baumol, 2001)



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One problem facing some poor countries is

the brain drain the emigration of many of the

most highly educated workers to rich countries.

People from poor countries with a valued

education can often earn far greater incomes

by moving to rich countries.



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2. Capital Formation

It is easier to do research and development with new

capital than with old capital. Also, more capital means there are

more resources available for consumption and investment, so there

will be a lower opportunity cost of doing research.

High rates of investment contribute to rapid

technological progress

Thus, the techniques for encouraging capital

formation can also encourage technology

development



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3. Research and Development

By directing more of an economys resources

towards research and development, thegovernment can directly influence the rate of

technological development



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Government Support for Research and

Development:

1. Subsidies for private R&D spendingthrough tax laws

2. Working together with private companies

involved in research3. Direct government spending on R&D



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Growth Policy: C: Encouraging Workforce

Quality Improvement (Human Capital)

More educated people earn higher wages

People with higher wages are generally more

productive.Thus, there is a direct link between education

and productivity. More education = higher

productivity (generally)



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In rich countries, primary education is a requirement

by law. It is also paid for through taxes, so everyone

can go to school.

Policies that raise high school rates of attendance

and completion can improve workforce quality.

Policies that improve the qualityof high schooleducation can improve workforce quality.

Unfortunately such policies are difficult to implement

effectively.2/12/2012 Prof. Rushen Chahal


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Sending more young people to college or trade

schools can improve workforce quality

On the job training can also prove valuable in

improving the quality of the workforce (Human

Capital)



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China has set the goal of giving every child an

education of at least 9 years by 2007

This is a big taskUnclear whether they will be required to pay

tuition



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The productivity speed-up and

slowdown in America



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Productivity Slowdown, 1973-1995

What caused it?

Growth slowed to about 1.4 percent during this

period

Possible reasons for this include:

1. Low investment

2. High energy prices

3. Low workforce skills (low Human Capital)

4. A technological slowdown

5. Increased environmental regulations



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What caused it? Low Investment?

U.S. businesses were not investing a lot (far less

than Germany and Japan)

BUT

Investment did not decline as a percentage of GDP

during this period, so low investment might not have

caused the productivity slowdown (previously, the

same level of investment and higher labor productivity

growth had occurred at the same time)



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What caused it? Low Investment?

1948-1973 1973-1995 1995-2002

Growth rate

of laborproductivity

2.8% 1.4% 2.4%

Contribution ofcapital

formation

0.9 1.0 1.6

Contribution oftechnology

1.9 0.4 0.8

Source: Bureau of Labor Statistics2/12/2012 Prof. Rushen Chahal


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What caused it? High Energy Prices?

OPEC raised oil prices sharply in 1973

Higher oil prices should reduce use of energy by

businesses, decreasing labor productivity.

Productivity fell worldwide, not just in the U.S.

BUT

Oil prices dropped in the 80s, but there was no

corresponding productivity increase at that time

So, high oil prices might not have caused the productivity

slowdown



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Productivity Slowdown, 1973-1995 What caused

it? Inadequate Workforce Skills (low Human Capital)?

A general belief that educational quality is declining

in the U.S.

Was it just a case of Americans getting stupider and

worse at their jobs?

Reflected by decreasing rates of standardized tests

and increased labor force share of low-skilled

uneducated immigrants.

Maybe . . . But

Attendance rates, graduation rates and educational

levels have all been steadily increasing over the

slowdown period

So, low workforce skills (low Human Capital) might not have caused

the productivity slowdown2/12/2012 Prof. Rushen Chahal

P d ti it Sl d 1973 1995


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What caused it? Technological

Slowdown?Possibly civilian innovation was still higher

earlier, in the 50s and 60s.

Possibly because the U.S. spends most of itsR&D on military developments

Time lag before new technology is adapted by

businesses


P d ti it Sl d 1973 1995


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What caused it? Technological

Slowdown?1948-1973 1973-1995 1995-2002

Growth rate


2.8% 1.4% 2.4%


formation

0.9 1.0 1.6


1.9 0.4 0.8

Source: Bureau of Labor Statistics2/12/2012Prof. Rushen Chahal


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What caused it?

A definite answer is still not known.



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Productivity Speedup

Starting in 1995, the U.S. economy

experienced a speedup in productivity growth

This has been attributed to:1. High Investment

2. Falling Energy Prices

3. Advances in Information Technology



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High Investment

An explosion in the IT industry lead to high

investment in the 90s

Investment as a percentage of real GDP rosefrom 9.1 percent in 1991 to 14.6 percent in

2000

A rise in the capital stock led to a rise inproductivity



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Surging Investment

Investment as

percentage of Real GDP,

1991

9%

91%

Investment

EverythingElse

Investment as

percentage of Real GDP,

2000

15%

85%

Investment

EverythingElse



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Surging Investment

1948-1973 1973-1995 1995-2002

Growth rate


2.8% 1.4% 2.4%


formation

0.9 1.0 1.6


1.9 0.4 0.8



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Falling Energy Prices

1996-1998 Energy Prices were falling.

This should signify a higher consumption of

energy by businesses, and thus higher

productivity

BUT

Oil prices fell in the 80s too, and there was no

corresponding rise in productivity

Maybe it is a combination of factors



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Advances in Information

TechnologyInnovation exploded in the 90s:

Computers => faster and cheaper

Telecommunications systems improved

Development of the internet

Probably also a reflection of the lag time it

took for businesses to fully take advantage of

these new technological advances. These

technologies were first developed before the

90s.2/12/2012 Prof. Rushen Chahal


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Advances in Information

Technology

1948-1973 1973-1995 1995-2002

Growth rate


2.8% 1.4% 2.4%


formation

0.9 1.0 1.6


1.9 0.4 0.8



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The Productivity Speedup

It seems that both capital formation and

technological change provide logical

explanations for the productivity speedupwitnessed in America recently



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A return to our initial question

Why does the relative price of college tuition

keep rising?



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1. As labor productivity increases, real wages

tend to rise at the same rate

When labor is able to produce more per hour,

it is generally paid more per hour



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2. In an economy, there are some services

where labor productivity cannot grow, or

growth is limited:

-Teaching

-Simple medical treatments

-Live performances

-Police officers-Chefs

In general, advances in technology do not affect the productivity

of these things.2/12/2012 Prof. Rushen Chahal


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3. Real wages in different occupations must

rise at similar rates

This might not hold true for the short run, but

eventually wages must rise at the same rates. This is

because ofopportunity cost. If wages for computer

scientists rise and wages for doctors do not, then

many people who would have become doctors would

become computer scientists instead. So, to haveenough doctors, doctors wages will have to rise with

the wages of everyone else.



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The labor productivity of teachers has not

increased as it has in other professions.

But wages for teachers must rise at the same

rates as professions where labor productivity

has increased.

So wages of teachers will rise faster than rises

in their productivity



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Because teachers wages rise faster than their productivity, their services

must become more expensive relative to other goods and services

This holds true for all industries where labor productivity growth is limited.

We call this problem the cost disease of the personal services

This is not the only explanation for increased cost. Others include higher

demand (more people go to college now than before) and increased

government subsidies for college (which leads to higher demand).

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Economic Growth Theory and Policy

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