Long-Run Economic Growth Growth Accounting Remember that we studied hat a countrys real GDP depends upon three

things: Amount of labor available Amount of capital available Total factor productivity Growth accounting says that long term GDP growth depends upon three things Rate of growth of the labor supply Rate of growth of the capital stock Rate of growth of total factor productivity Growth Accounting Equation- is the production function written in growth rate form.

! Y/Y Is the change in real GDP divided by the total amount of real GDP. This is Y equal to the percentage change in real GDPthe growth rate of real GDP. !A/A is the change in total factor productivity divided by the level of total factor. This is equal to the percentage change in total factor productivitythe rate of productivity growth. !N/N is the change in the labor supply divided by the total labor supply. This is equal to the percentage change in the labor supplythe growth rate of the labor supply. !K/k is the change in the capital stock divided by the total amount capital. This is K equal to the percentage change in the capital stockthe growth rate of capital. aN is called the elasticity of output with respect to labor. It is the percentage increase in output resulting from a 1% increase in labor used. aK is called the elasticity of output with respect to capital. It is the percentage increase in output resulting from a 1% increase in the capital stock. Growth Dynamics: The Solow Model We now take a look at a very popular model of economic growth, developed in the 1950s by Nobel Prize winning economist Robert Solow. There are a lot of symbols that go into this model. C consumption c consumption per worker = C/N d depreciation rate of the capital stock I investment K size of the capital stock k capital per worker = K/N N size of the labor supply n growth rate of the labor supply S national savings s the national savings rate = S/Y t a subscript used to denote year t

Y y

real GDP real GDP per worker = Y/N This is the dynamic production function. It indicates that for year t output per

y t = f (k t )
yt

worker, y, depends on the amount of available capital per worker.

yt = f(kt)

kt The production function slopes upward from left to right because an increase in the amount of capital per worker allows each worker to produce more output. The bowed shape reflects the diminishing marginal productivity of capital. Steady state is a situation in which the economy yt, ct, and kt are constant. In the steady state It is devoted in two purposes: Replacing capital. Expanding the size of the capital stock. In the steady state the gross domestic investment is:

I t = (n + d )K t
Golden rule - is the level of the K-L ratio that maximizes consumption per worker in the steady state. This is known by this name because it maximizes the economic welfare of future generations The Fundamental Determinants of LongRun Living Standards a. The Saving Rate If the saving rates increase there will be an increase in investment. This shifts the sf(k) upwards increasing the K-L ratio equilibrium point. b. Population Growth

This implies a change in n. An increase in the rate of population growth will reduce the steady state investment per worker. With higher population growth more output is used to equip new workers. This reduces the output available to consumptions or to increase capital per worker.

c.

Productivity Growth

The more we can produce per worker the more goodies we will enjoy with less inputs. This is the most important because: High saving does not translate into higher standard of living. The population growth is not likely to decrease In the long run, the rate of productivity improvement is the dominant factor determining how quickly living standards rise. Policies to affect the saving rate How can saving be increased? A way is to raise the real interest rate to encourage saving; but the response of saving to changes in the real interest rate seems to be small. Also the government could reduce the deficit or run a surplus Government Policies to Raise Long-Run Living Standards Improving Infrastructure: highways, bridges, utilities, dams, airports Building human capital. Government can encourage human capital formation through educational policies, worker training and relocation programs, and health programs. Encouraging research and development. Government can encourage R and D through direct aid to research