Chapter 17:Growth and Productivity:

Long-Run Possibilities

Copyright © 2013 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw-Hill/Irwin

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Economic Growth

• Economic growth is the fundamental determinant of the long-run success of any nation, the basis source of rising living standards, and the key to meeting the needs of the American people. —Economic Report of the President,

1992

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Learning Objectives

• 17-01. Know the principal sources of economic growth.

• 17-02. Know the policy tools for accelerating growth.

• 17-03. Know the pros and cons of continued growth.

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The Nature of Growth

• Short-run changes in capacity utilization:– The production possibilities curve (PPC) shows

our short-run limit of production capacity.– The economy often produces a mix of output

that lies inside the PPC.– The short-run goal is to achieve full

employment – that is, to move the economy out to the PPC.• We do this by putting to use all of our available

resources and our best expertise.

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The Nature of Growth

• Long-run change in capacity to produce:– To achieve large and lasting increases in output,

we must push the PPC outward – that is, to increase our productive capacity.

– Economic growth: an increase in output (real GDP); an expansion of production possibilities.

– Economic growth is also indicated on an AD-AS diagram as a rightward shift of long-run AS.• The natural rate of unemployment then shifts to a

higher rate of output (higher real GDP).

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Measures of Growth• Growth rate: percentage change in real GDP

from one year to the next.– Economic growth is an exponential process.– Small changes compound from year to year.

• A shortcut method of indicating growth rate is to use the Rule of 72:– To find how many years it takes to double GDP,

divide 72 by the growth rate.– At 3.5% growth rate, GDP will double in about 20

years.

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Measures of Growth

• GDP per capita: total real GDP divided by total population.– This is a measure of living standards.– It increases only when GDP growth exceeds

population growth.– In countries where population growth exceeds

GDP growth, living standards fall.

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Measures of Growth• GDP per worker: real GDP divided by the labor

force.– A measure of productivity.– If the labor force grows faster than the population,

GDP per capita grows and living standards rise.

• Productivity is better measured by output per labor-hour.– Increases in GDP per capita over recent decades are

due to the rising productivity of the average American worker.

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Sources of Growth

• Long-run growth of the labor force has stabilized, so continued growth in real GDP must rely on productivity growth.

Growth rate of Growth rate of Growth rate oftotal output = labor force + productivity

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Sources of Growth• Higher skills: an increase in labor skills.– Productivity gains reflect more schooling and more on-

the-job training.

• More capital: an increase in the ratio of capital to labor.– This is a primary determinant of labor productivity.– Saving is a basic source of investment financing.– Consumer saving is minuscule; business saving and

foreign investment have financed this contribution to our recent productivity gains.

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Sources of Growth• Technological advancements: development and

use of better capital equipment and products.– Come from research and development (R&D).– Scientific research.– Product development.– Innovations in production techniques.– All of these lead to new products and lower-cost ways of

producing them.• Improved management: better use of available

resources in the production process.– Fostering new entrepreneurship and improving the

quality of continuing management.

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New Growth Theory

• Old growth theory emphasized the importance of saving and investment in new plants and equipment – that is, capital goods.

• New growth theory emphasizes the importance of investing in ideas. Generating new ideas and the spread of knowledge are the primary engines of growth.

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Policy Tools

• Increase human capital investment.– Improve the quantity and quality of investment

in education.– Encourage employment-based immigration,

particularly of those with skills in short supply.

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Policy Tools

• Increase physical capital investment.– Expand investment incentives:• Faster depreciation schedules.• Tax credits for new investments.• Lower business taxes.

– Expand saving incentives.– Expand infrastructure development.– Return to fiscal responsibility.• Higher budget deficits lead to “crowding out.”

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Policy Tools

• Maintain stable expectations.– Uncertainty about the economic future affects

the behavior of both producers and consumers.– The following threats may inhibit investment:• Increasing government regulation.• Increasing inflation.• Increasing budget deficits and “crowding out.”• Increased business taxes.

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Policy Tools

• Create a favorable institutional context.– Greater economic freedom fosters faster

economic growth.• Secure property rights.• Open international trade.• Lower taxes.• Less regulation.

– This allows for more entrepreneurship and more opportunity and incentive to invest.