the long-run economic growth

ECON 1220 Principles of Macroeconomics Semester 2, 2011/12

1

The Long-Run Economic Growth

1. Economic Growth

Economists usually define economic growth as an increase in real GDP or real GDP per

capita:

o Real GDP per capita = Real GDP/Population.

o A measure of living standard.

The real GDP per capita growth rates

o U.S.: around 2.3% annually since 1950s

o China: around 8% annually sine 1980s.

The small difference in the growth rates makes a big difference in long term:

o The rule of 70 (mathematical approximation) shows that the approximate number of

years required to double real GDP per capita (or any variable) is 70 divided by the annual

growth rate (percentage change in the variable).

o Given the stable annual growth rate of 2.3%, U.S. will double its real GDP per capita in

70/2.3 = 30.43 years.


2

o If China maintains its annual growth rate of 8%, it will double its real GDP per capita in

70/8 = 8.75 years.

What are the sources of economic growth? Why some economies grow faster than others?

2. The Determinants of Economic Growth

What are the determinants of real GDP per capita1?

Population

employment T otal

employment T otal

GDP Real

Population

GDP Real

(EPR) Ratio Population toEmploymenttyProductiviLabor Population

GDP Real

Recall that in the classical model, the long-run output level (potential GDP) is determined by

the supply side. The amount of output an economy produces depends on two factors:

o The amounts of inputs (such as labor and capital) utilized in the production.

o The production technology to transform inputs into outputs.

Therefore, the major factors affecting labor productivity are:

o The amounts of other inputs, mainly capital.

o The production technology.

On the other hand, the EPR is determined by the labor market equilibrium.

3. Growth in Employment to Population Ratio (EPR)

With a given population, greater total employment means an increase in the EPR, and a rise in

real GDP per capita.

In the long run classical model, the total employment is determined by the labor market

equilibrium.

o What are the factors affecting labor demand and supply?

What government policies might affect labor demand and supply?

o Examples of policies that affect labor supply

Marginal income tax rate (supply-side economists)

Retirement age

Unemployment benefits reform

o Examples of policies that affect labor demand

Anything that helps to increase the labor productivity, such as subsidies for education

and training

Other policies that may affect the marginal benefits of employing labor such as

corporate tax or share of payroll tax contributed by employers

1 Here we measure labor by labor-hours, so it is equivalent to the equation in your textbook. Besides it is tedious to

distinguish average hours as it is relatively stable in most industrialized countries.


3

Is raising EPR a way to generate sustained economic growth?

o The maximum value of EPR is 1.

o EPR may rise and so create economic growth temporarily (while the ERR is rising). But

sustained economic growth would require significant, sustained growth in the EPR, which

is not realistic.

4. Growth in Productivity: The Increase in Capital Stock

The most important determinant of long-run economic growth is raising labor productivity.

In the classical model, the major factors affecting labor productivity (supply shocks) are:

o The amounts of other inputs, mainly capital.

Labor (L)

Real wage (W/P)

(W/P)

Labor (L)

Output (Y)

Production Function

LF1

YF1

LS1

LS2

LF2

YF2

LD

2

LD

1


4

o The production technology

To understand the determinants of the growth in capital level and its growth, we have to

examine how an economy’s capital stock accumulates:

The change in capital stock = planned investment – depreciation of existing capital.

Therefore, for a given rate of capital depreciation and given total employment, the major

determinant of the growth in capital stock is planned investment.

o In the classical model, the amount of planned investment (hence new capital stock) is

determined by the loanable market equilibrium.

o What are the factors affecting the demand and supply of loanable funds?

Labor (L)

Real wage (W/P)

(W/P)

Labor (L)

Output (Y)

LF1

YF1

LS

LF2

YF2

LD

2

LD

1

Y = f(K2, L)

Y = f(K1, L)


5

What government policies might affect loanable funds demand and supply?

o Examples of policies that affect the supply of loanable funds (household saving)

Consumption taxes

Capital gain taxes

o Examples of policies that affect the demand for loanable funds

Budget deficit (crowding out effect)

What kind of government spending to cut?

Public investment in infrastructure

Other policies that may affect the marginal benefits of investment such as corporate

profits tax or investment tax credit

So far we have focused on a single other input, physical capital only, but the economy’s other

inputs may include human capital.

o Human capital refers to the skills and knowledge possessed by labors.

o The amount of human capital labor would invest in involves the marginal benefits and

marginal costs comparison as in the cases of other input demand.

o To increase the investment in human capital, the government should pursue policies that

reduce the cost of investment (i.e. interest rate) and increase the benefits (i.e. profitability

of human capital to households).

Is increasing capital stock a way to generate sustained economic growth?

o Diminishing marginal returns.

o Given a fixed depreciation rate, increasing capital stock results in greater amount of

capital being depreciated each year. Much of the investment expenditure are used to

replace the capital worn out instead adding new capital.

5. Growth in Productivity: Technological Change

Economists generally agree that technology progress is the source of sustained economic

growth.

o Technological progress refers to the invention and use of new inputs, new outputs, or new

methods of production, which results in more output, given the same amount of inputs.

Economic growth, especially in develoed countries, is mainly based on discovery-based

growth (i.e. technological change from new discoveries)

In developing countries, sustained growth is largely catch-up growth (i.e. rapid technological

change by copying and adapting technologies already in use in rich countries)

How might government promote technological progress?

o Research & Development spending:

Subsidies

Direct spending on R&D

o Institutional infrastructure that encourages innovation

Enforcement of property right protection, such as patent (but there may be a counter

effect)

o International openness that encourages inflow of technology.


6

Empirical studies show that openness to international trade is good for economic

growth:

Sachs and Warner (1995):

o Among developed nations: the open economies grew at 2.3% per year, while

the closed economies grew at 0.7% per year.

o Among developing nations: the open economies grew at 4.5% per year,

while the closed economies grew at 0.7% per year.

Some countries trade less simply because they are geographically disadvantaged:

New Zealand is farther from other populous countries.

Landlocked countries are also disadvantaged compared to countries with their

own seaports, such as Hong Kong and Singapore.

o Legal institutions:

La Porta, Lopez-de-Silanes, Shleifer and Vishny (1998):

Legal protections for shareholders and creditors are stronger in English-style

legal systems (such as U.S., Australia, India, Singapore, Hong Kong) than

French-style legal systems (such as Italy, Spain and most of the Latin American

countries). As a result, the English-style countries have better-developed capital

markets. They, in turns, experience more rapid growth because it is easier for

small and start-up firms to finance investment projects, leading to more efficient

allocation of the nation’s capital.

6. Costs of Economic Growth

Budgetary cost

Consumption cost of brute force

Sacrifice of other social goal, such as income inequalities, hardship for those workinh in

traditional industries.

Readings:

Chapter 21

Consumption Goods (y)

B

Capital Goods (x)

C

Sep 24th 2011 | from the print edition

The world economy

Catching up is so very hard to doThe emerging economies have had a great decade. Thatwas the easy part

THIS month Italy’s government sold a slug offive-year paper at one of its regular bondauctions. There was barely enough demandfor the bonds to meet supply, even at a steepinterest rate. Contrast that with the sale inAugust of 20 billion yuan ($3.1 billion) ofpaper by China in Hong Kong’s fledglingoffshore market. The yield was miserly yet there were more than fourtimes as many bids as there were bonds for sale.

This tale of two bond auctions is a parable for the contrasting fortunesof near-stagnant rich economies and fast-growing emerging markets.Twenty of the 42 economies covered in the back pages of TheEconomist grew by 3% or more in the year to the latest quarter. Onlytwo of these, Austria and Sweden, are from the traditional group of richcountries. The rest are developing economies, such as Brazil andTurkey, or newly rich ones, such as Taiwan and Hong Kong. The IMF’slatest forecast is that emerging economies will grow by more than 6%in 2011 and 2012. But growth in the rich world is likely to be below2%.

The other half lives

The rotten economic news over the summer and the deepening euro-zone mess mean it is easy to forget that countries that now account forhalf the world’s output and most of its population are doing rather well.That is the focus of our special report

from the print edition | Leaders

(http://www.economist.com/node/21528979) on the world economythis week. But it is equally easy—and unwise—to think that rapid andtrouble-free growth in the emerging economies is assured for years tocome.

It seems almost churlish to question the outlook for emerging marketsafter the great strides they have made. China and India are twice asrich as they were a decade ago, taking millions out of poverty. Nor isthe good news confined to the two Asian giants. Even before the globalfinancial crisis battered the rich world, dozens of emerging marketswere growing at a faster rate than America, the world’s leadingeconomy. The crisis has merely widened what was already a large gap.

Yet the growth of emerging economies is unlikely to continue at thesame rapid pace or without occasional downturns. As economiesbecome richer, they can rely less and less on the brute force of capitalspending, coupled with a steady flow of cheap rural migrants, to fueltheir expansion. They have a greater need of a skilled workforce and amodern financial system that is attuned to where the best returns mightbe found. Countries that have leant on exporting cheap goods to therich world need instead to turn to internal sources of spending. Thatrisks the ills that have felled emerging markets in the past: excessivecredit, government spending and inflation.

Much depends on how well China manages its economic transition. TheHong Kong bond issue is one of the early steps China has taken toestablish the yuan as a global standard. Further strides would bewelcome: the financial crisis is proof that America cannot usefullyrecycle the world’s excess savings. The yuan’s acceptance amonginvestors would also require the kind of reform China needs to wean itseconomy from its investment-heavy, export-oriented growth model.

The shift will not be easy. The coming decade is therefore likely toprove harder for the emerging markets. China and others are enteringthe tricky middle-income stage of development in which the bigadvances from absorbing rich-world technology start to run out.Trouble has a habit of striking places that avoided the previous crisisand became overconfident. A broad sell-off in emerging-marketcurrencies in recent weeks may be an early sign of softer growthahead. The weight of the world economy is moving, with remarkablespeed, towards the populous emerging markets. But the transition isunlikely to be as smooth as many people assume.

Apr 14th 2011 | from the print edition

Economics focus

BRIC wallGrowth tends to slow when GDP per head reaches acertain threshold. China is getting close

THE economic crisis may have been debilitating for the rich world butfor emerging markets it has been closer to a triumph. In 2010 Chinaovertook a limping Japan as the world’s second-largest economy. Itlooks sets to catch America within a decade or two. India and Brazil aregrowing rapidly. The past few years have reinforced the suspicion ofmany that the story of the century will be the inexorable rise ofemerging economies. If projections of future growth look rosy foremerging markets, however, history counsels caution. The post-warperiod is rich in examples of blistering catch-up growth. But at somepoint growth starts to disappoint. Gaining ground on the leaders is fareasier than overtaking them.

Rapid growth is initially easy because the leader has already trodden aclear path. Developing countries can borrow existing technologies fromcountries that have already become rich. Advanced economies may bestuck with obsolete infrastructure; laggards can skip right to theshiniest and best. Labour productivity soars as poor economies shiftworkers from agriculture to a growing manufacturing sector. And rapidincome growth among young workers boosts savings and fuelsinvestment.

But the more an emerging economy resembles the leaders, the harder itis to sustain the pace. As the stock of borrowable ideas runs low, thedeveloping economy must begin innovating for itself. The supply ofcheap agricultural labour dries up and a rising number of workers takejobs in the service sector, where productivity improvements are moredifficult to achieve. The moment of convergence with the leaders,

which once seemed within easy reach, retreats into the future. Growthrates may slow, as they did in the case of western Europe and theAsian tigers, or they may falter, as in Latin America in the 1990s.

The world’s reliance on emerging markets as engines of growth lendsurgency to the question of just when this “middle-income trap” issprung. In a new paper* Barry Eichengreen of the University ofCalifornia, Berkeley, Donghyun Park of the Asian Development Bankand Kwanho Shin of Korea University examine the economic recordsince 1957 in an attempt to identify potential warning-signs. Theauthors focus on countries whose GDP per head on a purchasing-power-parity (PPP) basis grew by more than 3.5% a year for sevenyears, and then suffered a sharp slowdown in which growth dipped bytwo percentage points or more. They ignore slowdowns that occurwhen GDP per head is still below $10,000 on a PPP basis, limiting thesample to countries enjoying sustained catch-up growth. What emergesis an estimate of a critical threshold: on average, growth slowdownsoccur when per-head GDP reaches around $16,740 at PPP. The averagegrowth rate then drops from 5.6% a year to 2.1%.

This estimate passes thesmell test of history (seechart). In the 1970s growthrates in western Europeand Japan cooled off atapproximately the $16,740threshold. Singapore’searly-1980s slowdownmatches the model, asdoes the experience ofSouth Korea and Taiwan inthe late 1990s. As theseexamples indicate, adeceleration need not precipitate disaster. Growth often continues andmay accelerate again; the authors identify a number of cases in which aslowdown proceeds in steps. Japan’s initial boom lost steam in theearly 1970s, but its economy continued to grow faster than other richnations until its 1990s blow-up.

In the right circumstances the good times may be prolonged, allowingan economy to reach a higher income level before the inevitableslowdown. When America passed the threshold it was the world leaderand was able to keep growing rapidly so long as its own innovative

prowess allowed. Britain’s experience indicates economic liberalisationor a fortunate turn of the business cycle may also prevent the thresholdfrom binding at once.

Openness to trade appears to be a potent stimulant: the authorsattribute the outperformance of Hong Kong and Singapore to thiseffect. Lifting consumption to just over 60% of GDP is useful, as is alow and stable rate of inflation. Neither financial openness nor changesof political regime seem to matter much, but a large ratio of workers todependents reduces the odds of a slowdown. An undervalued exchangerate, on the other hand, appears to contribute to a higher probability ofa slowdown. The reason for this is not clear but the authors suggestthat undervaluation could lead countries to neglect their innovativecapacity, or may contribute to imbalances that choke off a boom.

Middle Kingdom, middle income

The authors are careful to say that there is no iron law of slowdowns.Even so, their analysis is unlikely to cheer the leadership in Beijing.China’s torrid growth puts it on course to hit the $16,740 GDP-per-head threshold by 2015, well ahead of the likes of Brazil and India.Given the Chinese economy’s long list of risk factors—including anolder population, low levels of consumption and a substantiallyundervalued currency—the authors suggest that the odds of aslowdown are over 70%.

It is hazardous to extend any analysis to a country as unique as China.The authors acknowledge that rapid development could shift inland,where millions of workers have yet to move into manufacturing, whilethe coastal cities nurture an ability to innovate. The IMF forecasts realGDP growth rates above 9% through to 2016; a slowdown to 7-8%does not sound that scary. But past experience indicates thatslowdowns are frequently accompanied by crises. In East Asia in thelate 1990s it became clear that investments which made sense atgrowth rates of 7%, say, did not at expansion rates of 5%. Politicalsystems may prove similarly vulnerable: it has been many years sinceChina has to deal with an annual growth rate below 7%. Structuralreforms can help to cushion the effects of a slowdown. It would bewise for China to pursue such reforms during fat years rather than theleaner ones that will, eventually, come.

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from the print edition | Finance and economics

* “When Fast Growing Economies Slow Down: International Evidence andImplications for China”. NBER working paper, March 2011

Jan 28th 2012 | from the print edition

China

The paradox of prosperityFor China’s rise to continue, the country needs to moveaway from the model that has served it so well

IN THISissue welaunch aweeklysectiondevotedtoChina. Itis thefirsttimesince webeganour detailed coverage of the United States in 1942 that we have singledout a country in this way. The principal reason is that China is now aneconomic superpower and is fast becoming a military force capable ofunsettling America. But our interest in China lies also in its politics: itis governed by a system that is out of step with global norms. In waysthat were never true of post-war Japan and may never be true of India,China will both fascinate and agitate the rest of the world for a longtime to come.

Only 20 years ago, China was a long way from being a globalsuperpower. After the protests in Tiananmen Square led to a massacrein 1989, its economic reforms were under threat from conservativesand it faced international isolation. Then in early 1992, like an emperor

undertaking a progress, the late Deng Xiaoping set out on a “southerntour” of the most reform-minded provinces. An astonishingendorsement of reform, it was a masterstroke from the man who mademodern China. The economy has barely looked back since.

Compared with the rich world’s recent rocky times, China’s progresshas been relentless. Yet not far beneath the surface, society ischurning. Recent village unrest in Wukan in Guangdong, one provincethat Deng toured all those years ago; ethnic strife this week in Tibetanareas of Sichuan; the gnawing fear of a house-price crash: all are signsof the centrifugal forces making the Communist Party’s job so hard.

The party’s instinct, born out of all those years of success, is to tightenits grip. So dissidents such as Yu Jie, who alleges he was tortured bysecurity agents and has just left China for America, are harassed. Yetthat reflex will make the party’s job harder. It needs instead to masterthe art of letting go.

China’s third revolution

The argument goes back to Deng’s insight that without economicgrowth, the Communist Party would be history, like its brethren in theSoviet Union and eastern Europe. His reforms replaced a failingpolitical ideology with a new economic legitimacy. The party’s cadresset about remaking China with an energy and single-mindedness thathave made some Westerners get in touch with their inner authoritarian.The bureaucrats not only reformed China’s monstrously inefficientstate-owned enterprises, but also introduced some meritocracy toappointments.

That mix of political control and market reform has yielded hugebenefits. China’s rise over the past two decades has been moreimpressive than any burst of economic development ever. Annualeconomic growth has averaged 10% a year and 440m Chinese havelifted themselves out of poverty—the biggest reduction of poverty inhistory.

Yet for China’s rise to continue, the model cannot remain the same.That’s because China, and the world, are changing.

China is weathering the global crisis well. But to sustain a high growthrate, the economy needs to shift away from investment and exportstowards domestic consumption. That transition depends on a fairerdivision of the spoils of growth. At present, China’s banks shovelworkers’ savings into state-owned enterprises, depriving workers of

spending power and private companies of capital. As a result, justwhen some of the other ingredients of China’s boom, such as cheapland and labour, are becoming scarcer, the government is wastingcapital on a vast scale. Freeing up the financial system would giveconsumers more spending power and improve the allocation of capital.

Even today’s modest slowdown is causing unrest (see article(http://www.economist.com/node/21543477) ). Many people feel thattoo little of the country’s spectacular growth is trickling down to them.Migrant workers who seek employment in the city are treated assecond-class citizens, with poor access to health care and education.Land grabs by local officials are a huge source of anger. Unrestrainedindustrialisation is poisoning crops and people. Growing corruption iscausing fury. And angry people can talk to each other, as they nevercould before, through the internet.

Party officials cite growing unrest as evidence of the dangers ofliberalisation. Migration, they argue, may be a source of growth, but itis also a cause of instability. Workers’ protests disrupt production andthreaten prosperity. The stirrings of civil society contain the seeds ofchaos. Officials are particularly alive to these dangers in a year inwhich a new generation of leaders will take power.

That bias towards control is understandable, and not merely self-interested. Patriots can plausibly argue that most people have plenty ofspace to live as individuals and value stability more than rights andfreedoms: the Arab spring, after all, had few echoes in China.

Yet there are rights which Chinese people evidently do want. Migrantworkers would like to keep their limited rights to education, health andpensions as they move around the country. And freedom to organisecan help, not hinder, the country’s economic rise. Labour unions helpindustrial peace by discouraging wildcat strikes. Pressure groups cankeep a check on corruption. Temples, monasteries, churches andmosques can give prosperous Chinese a motive to help provide welfare.Religious and cultural organisations can offer people meaning to lifebeyond the insatiable hunger for rapid economic growth.

Our business now

China’s bloody past has taught the Communist Party to fear chaosabove all. But history’s other lesson is that those who cling to absolutepower end up with none. The paradox, as some within the party arecoming to realise, is that for China to succeed it must move away from

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from the print edition | Leaders

the formula that has served it so well.

This is a matter of more than intellectual interest to those outsideChina. Whether the country continues as an authoritarian colossus,stagnates, disintegrates, or, as we would wish, becomes both freer andmore prosperous will not just determine China’s future, but shape therest of the world’s too.

the long-run economic growth

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