Potential GDP and Economic Growth

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1 Potential GDP and Economic Growth CHAPTER17 C H A P T E R C H E C K L I S T When you have completed your study of this chapter, you will be able to 1 Explain the forces that determine potential GDP and the real wage rate and employment at full employment. 2 Define and calculate the economic growth rate, and explain the implications of sustained growth. 3 Identify the main the sources of economic growth and explain the growth process. 4 Describe the policies that might speed economic growth. 1

2 MACROECONOMIC APPROACHES AND PATHWAYS The Two Main Schools of Thought The two main approaches to macroeconomics are based on two schools of thought: Classical macroeconomics Keynesian macroeconomics MACROECONOMIC APPROACHES AND PATHWAYS Classical macroeconomics is a body of theory about how a market economy works and why it experiences economic growth and fluctuations. The classical view is that markets work well and deliver the best available macroeconomic performance. The economy will fluctuate, and growth will slow down from time to time. But no government remedy can improve the performance of the market. MACROECONOMIC APPROACHES AND PATHWAYS Classical macroeconomic fell into disrepute during the 1930s, which was a decade of high unemployment and stagnant production throughout the world. Great Depression is a decade (the 1930s) of high unemployment and stagnant production throughout the world economy. Classical macroeconomics predicted that the Great Depression would end but gave no method for ending it more quickly. 2

3 MACROECONOMIC APPROACHES AND PATHWAYS Keynesian macroeconomics is a body of theory about how a market economy works that stresses it inherent instability and the need for active government intervention to achieve full employment and sustained economic growth. John Maynard Keynes, in his book The General Theory of Employment, Interest, and Money, began this school of thought. Keynes theory was that too little consumer spending and investment lead to the Great Depression. MACROECONOMIC APPROACHES AND PATHWAYS Keynes solution to depression and high unemployment was increased government spending. But Keynes predicted that his policy aimed at curing unemployment in the short term might increase it in the long term. This prediction became reality during the 1960s and 1970s, when inflation exploded, growth slowed, and unemployment increased. It was time for another challenge to the mainstream: new macroeconomics MACROECONOMIC APPROACHES AND PATHWAYS The New Macroeconomics New macroeconomics is a body of theory about how a market economy works based on the view that macro outcomes depend on micro choices the choices of rational individuals and firms interacting in markets. New classical macroeconomics incorporates the ideas of classical economists that markets work and new Keynesian macroeconomics incorporates the ideas of Keynesian economists that markets adjust slowly. 3

4 MACROECONOMIC APPROACHES AND PATHWAYS The key difference between the two new schools is in their view of how quickly price and wages adjust in the face of excess demand or excess supply. But this difference is tiny, and a consensus is emerging. The Road Ahead We follow the new consensus and begin with an explanation of what determines real GDP and employment and the pace of economic growth POTENTIAL GDP Potential GDP is the level of real GDP that the economy would produce if it were at full employment. We produce the goods and services that make up real GDP by using factors of production: labor and human capital, physical capital, land, and entrepreneurship. At any given time, the quantities of human capital, physical capital, land, entrepreneurship, and the state of technology are fixed POTENTIAL GDP The quantity of labor employed depends on the choices of people and businesses. So real GDP produced depend on the quantity of labor employed. To describe the relationship between real GDP and the quantity of labor employed, we use a relationship called the production function. 4

5 17.1 POTENTIAL GDP The Production Function Production function is a relationship that shows the maximum quantity of real GDP that can be produced as the quantity of labor employed changes and all other influences on production remain the same POTENTIAL GDP Figure 17.1 shows the production function. 100 billion hours of labor can produce $6 trillion of real GDP at point A POTENTIAL GDP 200 billion hours of labor can produce $10 trillion of real GDP at point B. 300 billion hours of labor can produce $12 trillion of real GDP at point C. The production function PF is a limit to what is attainable. 5

6 17.1 POTENTIAL GDP The production function is a boundary between the attainable and the unattainable. The production function displays diminishing returns: The tendency for each additional hour of labor employed to produce successively smaller additional amounts of real GDP POTENTIAL GDP The Labor Market The Demand for Labor Quantity of labor demanded is the total labor hours that all the firms in the economy plan to hire during a given time period at a given real wage rate. 6

7 17.1 POTENTIAL GDP Demand for labor is the relationship between the quantity of labor demanded and real wage rate when all other influences on firms hiring plans remain the same. The lower the real wage rate, the greater is the quantity of labor demanded POTENTIAL GDP Figure 17.2 shows the demand for labor. 7

8 17.1 POTENTIAL GDP The Supply of Labor Quantity of labor supplied is the number of labor hours that all the households in the economy plan to work during a given time period and at a given real wage rate. Supply of labor is the relationship between the quantity of labor supplied and the real wage rate when all other influences on work plans remain the same POTENTIAL GDP Figure 17.3 shows the supply of labor. 8

9 17.1 POTENTIAL GDP The quantity of labor supplied increases as the real wage rate increases for two reasons: Hours per person increase as the real wage rate increases. The labor force participation rate increases as the real wage rate increases POTENTIAL GDP Labor Market Equilibrium A rise in the real wage rate eliminates a shortage of labor by decreasing the quantity demanded and increasing the quantity supplied. A fall in the real wage rate eliminates a surplus of labor by increasing the quantity demanded and decreasing the quantity supplied. If there is neither a shortage nor a surplus, the labor market is in equilibrium POTENTIAL GDP Figure 17.4(a) shows labor market equilibrium. 1. Full employment occurs when the quantity of labor demanded equals the quantity of labor supplied. 2. Equilibrium real wage rate is $30 an hour. 3. Full-employment quantity of labor is 200 billion hours a year. 9

10 17.1 POTENTIAL GDP Full Employment and Potential GDP When the labor market is in equilibrium, the economy is at full employment. When the economy is at full employment, real GDP equals potential GDP POTENTIAL GDP Figure 17.4(b) shows potential GDP. 1. When the fullemployment quantity of labor is 200 billion hours a year, 2. Potential GDP is $10 billion. 10

11 17.2 THE BASICS OF ECONOMIC GROWTH Economic growth is a sustained expansion of production possibilities measured as the increase in real GDP over a given period. Calculating Growth Rates Economic growth rate is the rate of change of real GDP expressed as a percentage per year THE BASICS OF ECONOMIC GROWTH To calculate this growth rate, we use the formula: Growth of real GDP = Real GDP in current year Real GDP in previous year Real GDP in previous year x 100 For example, if real GDP in the current year is $8.4 trillion and if real GDP in the previous year was $8.0 trillion, then the growth rate of real GDP is Growth of real GDP = $8.4 trillion $8.0 trillion $8.0 trillion x 100 = 5 percent. 11

12 17.2 THE BASICS OF ECONOMIC GROWTH The standard of living depends on real GDP per person. Real GDP per person is real GDP divided by the population. The contribution of real GDP growth to the change in the standard of living depends on the growth rate of real GDP per person THE BASICS OF ECONOMIC GROWTH We use the above formula to calculate this growth rate, replacing real GDP with real GDP per person. Suppose, for example, that in the current year, when real GDP is $8.4 trillion, the population is 202 million. Then real GDP per person is $8.4 trillion divided by 202 million, which equals $41,584. And suppose that in the previous year, when real GDP was $8.0 trillion, the population was 200 million. Then real GDP per person in that year was $8.0 trillion divided by 200 million, which equals $40, THE BASICS OF ECONOMIC GROWTH Use these two values of real GDP per person in the growth formula to calculate the growth rate of real GDP per person. It is Growth rate of real GDP per person $41,584 $40,000 = $40,000 x 100 = 4 percent. 12

13 17.2 THE BASICS OF ECONOMIC GROWTH The growth rate of real GDP per person can also be calculated by using the formula: Growth of real = GDP per person Growth rate of real GDP Growth rate of population Growth of population = 202 million 200 million 200 million x 100 = 1 percent THE BASICS OF ECONOMIC GROWTH Growth of real GDP per person = 5 percent 1 percent = 4 percent. This formula makes it clear that real GDP per person grows only if real GDP grows faster than the population grows. If the growth rate of the population exceeds the growth of real GDP, real GDP per person falls THE BASICS OF ECONOMIC GROWTH The Magic of Sustained Growth Sustained growth of real GDP per person can transform a poor society into a wealthy one. The reason is that economic growth is like compound interest. Rule of 70 is the number of years it takes for the level of any variable to double is approximately 70 divided by the annual percentage growth rate of the variable. 13

14 17.2 THE BASICS OF ECONOMIC GROWTH Table 17.1 Growth Rates Growth rate Years for level (% per year) to double Example 2 35 U.S. real GDP per person 7 10 China real GDP per person 17.3 THE SOURCES OF ECONOMIC GROWTH To understand what determines the growth rate of real GDP, we must understand what determines the growth rates of the factors of production and rate of increase in their productivity. All the influences on real GDP growth can be divided into those that increase Aggregate hours Labor productivity 17.3 THE SOURCES OF ECONOMIC GROWTH Aggregate Hours Over time, aggregate hours increase. This growth in aggregate hours comes from growth in the labor force rather than from growth in average hours per worker. While the participation rate has increased over the past few decades, it has an upper limit, and most of the growth of aggregate hours comes from population growth. So population growth is the only source of growth in aggregate labor hours that can be sustained over long periods. 14

15 17.3 THE SOURCES OF ECONOMIC GROWTH Population growth brings economic growth, but it does not bring growth in real GDP per person unless labor becomes more productive. Labor Productivity Labor productivity is the quantity of real GDP produced by one hour of labor. It is calculated by using the formula: Real GDP Labor productivity = Aggregate hours 17.3 THE SOURCES OF ECONOMIC GROWTH For example, if real GDP is $8,000 billion and if aggregate hours are 200 billion, then we can calculate labor productivity as Labor productivity = $8,000 billion 200 billion = $40 per hour You can turn this formula around and see that Real GDP = Aggregate hours x Labor productivity 17.3 THE SOURCES OF ECONOMIC GROWTH When labor productivity grows, real GDP per person grows, so the growth in labor productivity is the basis of rising living standards. The growth of labor productivity depends on three things: Saving and investment in physical capital Expansion of human capital Discovery of new technologies 15

16 17.3 THE SOURCES OF ECONOMIC GROWTH Saving and Investment in Physical Capital Saving and investment in physical capital increase the amount of capital per worker and increase labor productivity. Expansion of Human Capital Human capital the accumulated skill and knowledge of people comes from two sources: Education and training Job experience 17.3 THE SOURCES OF ECONOMIC GROWTH Discovery of New Technologies To reap the benefits of technological change, capital must increase. Some of the most powerful and far-reaching technologies are embodied in human capital. For example, language, writing, and mathematics. But most technologies are embodied in physical capital THE SOURCES OF ECONOMIC GROWTH Sources of Growth: A Summary Figure 17.5 shows the sources of economic growth. Real GDP growth depends on aggregate labor hours growth and on labor productivity growth. 16

17 17.3 THE SOURCES OF ECONOMIC GROWTH Aggregate hours growth depends on Population growth The labor force participation rate Average hours per worker 17.3 THE SOURCES OF ECONOMIC GROWTH Labor productivity growth depends on Physical capital growth Human capital growth Technological advances 17

18 17.3 THE SOURCES OF ECONOMIC GROWTH Figure 17.6 illustrates the growth process as a perpetual motion machine. 1. People want a higher standard of living and are spurred by Profit incentives to make the Innovations that lead to THE SOURCES OF ECONOMIC GROWTH 4. New and better techniques and new and better products, which in turn lead to The birth of new firms and the death of some old firms, 6. New and better jobs, and More leisure and more consumption goods and services THE SOURCES OF ECONOMIC GROWTH The result is A higher standard of living. But people want a yet higher standard of living, and the growth process continues. 18

19 25.4 ACHIEVING FASTER GROWTH Preconditions for Economic Growth Economic freedom is the fundamental precondition for creating the incentives that lead to economic growth. Economic freedom is a condition in which people are able to make personal choices, their private property is protected, and they are free to buy and sell in markets ACHIEVING FASTER GROWTH Economic freedom requires the protection of private property the factors of production and goods that people own. Property rights are the social arrangements that govern the protection of private property. Economic freedom also requires free markets. 19

20 25.4 ACHIEVING FASTER GROWTH To achieve faster economic growth, we must increase The growth rate of capital per hour of labor or The growth rate of human capital or The pace of technological advance ACHIEVING FASTER GROWTH Policies to Achieve Faster Growth The main actions that governments can take to achieve these objectives are Create the incentive mechanisms Encourage saving Encourage research and development Encourage international trade Improve the quality of education 25.4 ACHIEVING FASTER GROWTH Create Incentive Mechanisms Economic growth occurs when the incentive to save, invest, and innovate is strong enough. These incentives exist only when private property is protected. Encourage Saving Saving finances investment, which brings capital accumulation. Tax incentives can encourage saving, increase the growth of capital, and stimulate economic growth. 20

21 25.4 ACHIEVING FASTER GROWTH Encourage Research and Development Everyone can use the fruits of basic research and development efforts. Because basic inventions can be copied, the inventor s profit is limited and so the market allocates too few resources to this activity. Governments can direct public funds toward financing basic research, but it requires a mechanism for allocating public funds to their highest-valued use ACHIEVING FASTER GROWTH Encourage International Trade Free international trade stimulates economic growth by extracting all the available gains from specialization and trade. Improve the Quality of Education By funding basic education and by ensuring high standards in skills such as language, mathematics, and science, governments can contribute enormously to a nation s growth potential ACHIEVING FASTER GROWTH How Much Difference Can Policy Make? A well-intentioned government cannot dial up a big increase in the growth rate. But it can pursue policies that will nudge the growth rate upward. And over time, the benefits from these policies will be large. 21

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