introduction to economic growth (1) - manoel...

Introduction to economic growth (1)EKN 325

Manoel Bittencourt

University of Pretoria

M Bittencourt (University of Pretoria) EKN 325 1 / 32

Introduction

In the last century the USA has experienced a tenfold increase inincome. In addition, income in the USA and western Europe isfifty times higher than in sub-Saharan Africawhy are economic growth rates important? Do they make anydifference in the long run in terms of welfare? If so, how?during the 1989 meetings of the American Economic Association,the Harvard economic-historian David Landes posed thequestion: ‘Why are we so rich and they so poor?’,http://www.jstor.org/stable/pdfplus/2006534.pdf


Introduction

Moving a little back in time, Adam Smith called his 1776 magnumopus ‘An inquiry into the nature and causes of the Wealth of Nations’and Thomas Malthus was so concerned about the futureprospects for growth in the 19th century (recall the Malthusianprediction) that Economics became known as the ‘dismal science’back to the 20th century, modern economic growth theory beginswith MIT’s Robert Solow in the 1950s with the publication of histwo papers on the subject (which earned him the Nobel Prize in1987)


Introduction

The papers by Solow highlight the role of physical capitalaccumulation, and more importantly, the role of technologicalprogress as the engine of sustained economic growth. However, inthese papers technology is exogenous, or a residualin the 1960s a group of economists, including (among others)Nobel Prize winners Kenneth Arrow and Edmund Phelps, triedto extend and improve the Solow model with their AK modelsin the 1980s economists at Chicago, Paul Romer and Robert Lucas(a Nobel prize winner himself), taking advantage of the newmathematical and economic techniques then available, proposedmodels which were based on the 1960s AK models and thesemodels of endogenous growth incorporated the role of ideas andhuman capital (technology was/is at the forefront of economicgrowth)


Introduction

In the 1990s, with the availability of new data sets, economistsstarted testing these models (Robert Barro from Harvard startedthe cross-country studies which led to an explosion of empiricalstudies about the determinants of growth)up to this point in time (2017), economic growth is probably thehottest area in macroeconomics, with better data sets andimprovements in econometrics, not to mention better theoreticalmodels, more and more researchers are investigating the causes ofeconomic growth and prosperity worldwidemoreover, most of those involved in this research project havealready been either awarded with the Nobel Prize (Solow, Arrow,Phelps, Lucas), or will be in the near future (Romer and Barro),which illustrates the importance of the topic in currentmacroeconomics


Introduction

A word of caution is required though, growth and developmentare associated with policy implementation, however beforeimplementing policies which are conducive to growth, we have tofirst understand what are the causes of growth and developmentso that better policies can be implemented


Introduction

Figure: Lights and development, or is it the other way round?


The data of growth and development

The world is a heterogeneous place, there are countries which arerich, especially when compared to some less fortunate ones, otherswhich are poor and others in the middle of the distribution (or intransition)more fundamentally, some countries are growing fast (China andIndia), others not growing so fast (South Africa) and some notgrowing at all (Somalia)so, we are going to initially check some data, or facts, on growthand development, or how the rich fare in terms of GDP per capita,or per worker, and how the poor and the not so poor fare as well



Bear in mind that most of the data used here are freely availablefrom the web, the Penn World Table is available from

I http://cid.econ.ucdavis.edu/pwt.html,

and Maddison’s historical datasets are available fromI http://www.ggdc.net/databases/index.htm,

and the Gapminder, which provides a more dynamic view ofgrowth,

I http://www.gapminder.org/

and there are links to these pages from my website



Fact 1, there is significant variation in per capita income acrosscountries, or heterogeneity amongst countries. For instance, someof the poorest countries have incomes per capita which are only5% of the income in the richest countries. The differences in livingstandards are staggering!table 1.1 reports some statistics, the first column reports the realGDP per capita (GDP/population) in 2008 US$ in different groupsof countries; rich, poor, economic miracles and disasters



An aside is the purchasing power parity (PPP) theory, or theadjusted exchange rate. The PPP is used to measure the ability of aparticular currency to buy similar products elsewhere, so it takesinto account the cost of living in particular countries. For instance,the Economist magazine makes available the Big-Mac index (if theBig Mac costs US$ 3.00 in the USA and 300 yen in Japan, then thePPP is 100 yen per dollar—bear in mind that the Big Mac is ahomogeneous product world wide, so such comparisons arepossible). Extending the sample to a number of products (or abasket of products) we can construct a PPP exchange rate that canbe used for international comparisons, which is much less volatilethan the current exchange rate



Table 1.1 is interesting for a number of reasons, the second columnprovides information on GDP per worker, or (GDP/labourforce).The third column provides information on labour forceparticipation, the ratio of the labour force to population(labourforce/population), or effort in producing outputbut then the question is, which measure should we use for welfarecomparisons amongst different countries? It is now widelyaccepted that the GDP per capita is a reasonable indicator ofeconomic welfare. However, also bear in mind that the GDP perworker can be a reasonable indicator of productivity or of howproductive the labour force is in a particular country



Now let’s look at what the numbers are telling us; India andNigeria have GDPs which are less than 10% of the one in the USA.Additionally, the USA GDP is more than 60 times higher than theGDP in Ethiopiain other words, a worker in Malawi has to work for two months toearn what a similar worker earns in a day in the USA. Moreover,approximately 40% of the GDP is spent on food in Ethiopia, in theUS only 7% of the GDP is spent on foodon the top of that, figure 1.1 shows that in 2008 two-thirds of theworld’s population lived in regions with less than 20% of the USAGDP per worker. China and India are pushing this up a bit, giventhe size of their populations, however this is still significant



However, figure 1.2 also shows how this distribution has(is)changing since the 1960s, and the distribution has, in fact,equalised. The share of the world population living in countries inwhich the GDP per worker is less than 10% of that in the USA hasdecreased over time. Again, China and India are playing animportant role, since they are the countries which have seensubstantial increases in their GDPs per worker (even relative tothe USA)



Another important information contained in table 1.1 relates togrowth miracles, or the newly industrialising countries (NICs)such as Hong Kong, Singapore, Taiwan and South Korea. Thesecountries have been growing consistently fast and that has had aneffect on GDP per capita and per worker, or on the amount ofoutput available in those economies (needless to mention Chinaand India as well, with their recent high growth rates)Fact 2, the rates of economic growth display enormous differencesamongst different countries. Table 1.1 provides information aboutgrowth rates across countries (the average of annual changes inthe natural log of GDP per capita) from 1960 to 2008the NICs (growth miracles) display rates of growth which arehigher than the ones in more mature countries, except Japan.However, some countries also display negative growth rates(growth disasters), in particular sub-Sahara African countries (butnot only)



An aside relates to how to calculate growth rates. An easy way issimply g = y2005�y2004

y2004, or alternatively yt+1�yt

yt= g. An useful

manipulation from the above delivers yt+1 = yt(1+ g), this candetermine the value of per capita income in yt+1 if we know ytand gmoreover, an useful interpretation and application of the growthrates was proposed by Lucas, a country growing at g percent peryear doubles its per capita income every 70/g years. For instance,the US doubles its GDP per worker approximately every 43 years[70/1.6]! That means that in a matter of less than 2 generations atypical American will be 2 or 3 times as rich as his grandparentsfor example, if yt grows at 2% per year, then y doubles every70/2 = 35 years



All in all, growth rates matter, in a short period of time differentgrowth rates seen in different countries make significantdifferences in per capita income and therefore in the livingstandards of the populationFact 3, growth rates are not constant over time. In fact, growthrates were virtually zero for most of documented human history(the Malthusian stagnation), growth is indeed a new developmentin the history of humankind, a matter of 200 years or sothe 20th century has seen incredible growth rates, even when wetake into consideration modest growth rates of 2% per year.Historically, humankind has lived in a stationary (Malthusianstagnation) period until approximately 1790 when modernsustained growth begins



More specifically, between 1950 and 2008 world per capita GDPgrew at 2.6% per year. Between 1870 and 1950 world per capitaGDP grew at 1.10% per year. However, before 1850 world percapita GDP grew a mere 0.2% per year!

I an aside is, how do we calculate the growth rates in the USA

between 1870 and 2004? By simply using g =��

yty0

�1/t� 1

�, and

substituting�

37,5002,500

�1/135� 1 = 0.02, or 2% over the period

Angus Maddison suggests that between 500 CE and 1500, growthrates averaged zero! Again, growth is a modern phenomenon, justlike electricity



All in all, because of this recent growth, the world per capita GDPtoday is 15 times higher than in 1500. Again, the differences inliving standards are staggering!growth within countries is also of interest. For instance, Mauritiuspresented negative growth rates between 1950 and 1970. However,between 1970 and 2008 Mauritius grew at 3.1% per year. China isanother example, during 1960 to 1978 the country grew at 2.1%per year. However, since 1979 China’s GDP per worker hasgrown, on average, at 7.7% per yearthe above leads to another fact of economic growth,



Fact 4, the position of particular countries in the distribution ofper capita income is not immutable, countries can move from alow position in the distribution to a high one, and vice versathink of Argentina, one of the richest countries just a matter of 100years ago, and now it has only about one-third of the USA percapita income, or Finland, a poor country 100 years ago ... so,mobility is possible


Other ‘Stylised Facts’

The 4 facts seen above apply to the countries of the world ingeneral. The next fact applies mostly to the USA, however it isimportant to understand what happens in the USA since they area country which went through different stages of development,therefore useful. Moreover, some of the USA features areimportant for most economies in the long runFact 5, in 20th-century USA; firstly, the real rate of return to capitalr has presented no trend whatsoever; secondly, the shares ofincome devoted to capital and labour have presented no trendeither; thirdly, the average growth rate of output per capita hasbeen positive and constant over the period (these are the Kaldorfacts)the first statement above is simply telling us that the real interestrate in the USA has no trends (upward or downward)

I recall that to get the real interest rate you have to discount the effectof inflation from it (r = i� π)



The second statement is about the factors of production, capital Kand labour L. With information on salaries, wages andself-employment remuneration we can get the ratio(labourshare/GDP). This labour share has been constant over time,around 0.7needless to say that if the labour share is constant, the capitalshare must be constant over time too, around 0.3, recall the simpleCobb-Douglas production function (Y = K, L)the third statement is better illustrated by figure 1.4, which showsthe growth of GDP per capita in the USA between 1870 and 2008.The long-run trend is positive all over the period, so the questionis, what is causing growth then?



Fact 6, growth in GDP and growth in the volume of internationaltrade, or openness for short, are positively correlated in across-section of countries. The volume of trade is defined as thesum of exports and imports over GDP (x+m/gdp)



Fact 7, skilled and unskilled workers migrate from poor to richcountries. That implies that wages are higher in rich countries, sothe migration. However, the question is ‘does it make any economicsense’? If skilled labour is scarce in developing and poor countries(which also implies higher wages in those countries), why thenhighly-skilled Africans keep migrating to the UK, Australia,Holland and USA in large numbers?


The road ahead

Why are we so rich and they so poor?what is the engine of economic growth? If technological progress isthe missing link, then we should also ask ‘what determinestechnological progress’?how can we account for growth miracles?is modern growth sustainable? How about the role of naturalresources?


The road ahead

Understanding what causes economic growth is vital, the NICsare examples that (upward) mobility is possible. Moreover,Argentina, one of the richest countries in the world a mere 100years ago, is an example of (downward) mobility. Economicgrowth has the potential of increasing living standards in a matterof a generation. Lucas, in his Marshall Lecture at Cambridge in1988, stated:

‘I do not see how one can look at figures like these withoutseeing them as representing possibilities. ... The consequences forhuman welfare involved in questions like these are simplystaggering: Once one starts to think about them, it is hard to thinkabout anything else.’


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