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Economic Growth

Terms
Capital - Physical and intellectual property that is utilized by labor in the production of goods and services. Capital Expenditure - Money spent on increasing the amount of capital in a firm or an economy. Capital Stock - The total amount of capital in an economy or in a firm. Convergence - The theory that all industrialized countries tend to approach one another over time in terms of GDP per capita. GDP per Capita - Nominal GDP divided by the total population. This indicates the amount of a countrys total output that each member of the population theoretical has access to. Golden Rule Level of Capital - The level of capital where consumption and savings are optimized. Growth Level - The long term rate of growth. Growth Rate - The short term rate of growth. Human Capital - Intellectual property, like education and scientific discoveries, that affects the level of output in a firm or country. Industrialized - Describes countries that have an infrastructure and government amenable to industrial development. Infrastructure - Physical machinery and transportation that is in place to aid in industrialization. International Market - The market for goods and services that spans countries. Labor - Workers who utilize capital to produce output. Labor Productivity Growth - An increase in the amount of output a given unit of labor can produce. Nominal GDP - The total currency value of all goods and services produced in a national economy. Open Market - A market for the sale and purchase of goods and services in which all countries may compete. Output - Goods and services produced by firms. Physical Capital - Machinery used by labor in the production of goods and services. Production - The creation of output. Production Capabilities - The capital that allows a given amount of potential output. Productivity - The ability to produce output. Prosperity - The creation of a high standard of living. Savings Rate - The percentage of total income that is saved for future consumption. Standard of living - The level of economic wellbeing enjoyed by members of a population. Technological Progress - The advancement of technology over time due to scientific discoveries. Trade - The purchase and sale of goods and services between entities. Unemployment - The condition of being without a job but also actively searching for one.

Wage - Money paid or received in exchange for labor.

Labor productivity growth

Increasing productivity
When looking at what makes an economy grow in the long run, it is imperative to begin by examining how output is created. Firms use a combination of labor and capital to produce their output. Labor consists of the workers and employees who produce, manage, and process production. Capital describes both the ideas needed for production and the actual tools and machines used in production. Ideas and other intellectual property are called human capital. Machinery and tools are called physical capital. Firms use some combination of labor and capital to produce output. In particular, the labor utilizes the capital in the production process. For example, when making cars, workers use tools and an assembly line to produce a finished product. The workers are the labor and the machines are the capital. In order to increase productivity, each worker must be able to produce more output. This is referred to as labor productivity growth. The only way for this to occur is through an in increase in the capital utilized in the production process. This increase can be in the form of either human capital or physical capital. An example will help to illustrate the basic way that labor productivity growth works through increases in the capital stock. Say there is a riveter named Joe. Joe works in a factory that makes metal boxes that are riveted together. He has a riveting tool that can rivet at a rate that allows Joe to finish 4 metal boxes every hour. Joe's labor productivity is thus 4 boxes per hour. One day, Joe gets a second riveting tool. With two tools, Joe can produce 8 metal boxes every hour. Now Joe's labor productivity has increased from 4 boxes per hour to 8 boxes per hour. The increase in the physical capital available to Joe, that is, a second tool, allowed this increase in Joe's labor productivity. For every hour of work Joe puts in, he can produce 100% more output due to an increase in the physical capital available to him. Another example may also be of use. Say there is a chef named Susan. Susan can cook 10 hamburgers in an hour. One day, she decides to go to the Hamburger Cooking School to learn how to cook hamburgers faster. When she returns to work, she is able to cook 40 hamburgers per hour by utilizing the new tricks she learned. By attending the cooking school, Susan increased her human capital and thus increased her labor productivity. It is important to remember that increases in capital can take the form of both quantity and quality increases. From these two examples, it is clear that the only way to achieve labor productivity growth is to increase the amount of capital, physical and/or human, available to workers. And in the long run, the only way for overall productivity to increase is though increases in the capital used in production.

Growth level vs. growth rate


When discussing growth, there is an important distinction that must be made. The growth level is the starting value of whatever is growing; the growth rate is the change in the growth level from year to year. These distinctions allow for accurate descriptions of economic policies on long-run growth. An example will help to illustrate the level vs. rate distinction. Let's use the idea of capital presented in the preceding section. Say a company owns 50 riveting tools like the one used by Joe. In order to increase output, the company decides to purchase 5 new riveting tools next year. In this case, the level of capital is 50 because this is the amount that the firm began with. The growth rate of capital is 10% because from one year to the next the amount of capital used by Joe's firm increased by 10%.

Changes in growth rate vs. changes in the growth level over time
Now that the growth rate vs. growth level distinction is clear, let's apply it to the way that economic policies affect productivity. The most important number in increasing economic productivity is the growth level. The growth level shows where the economy is relative to long term positioning. For instance, we know that the economy tends to grow at about 2% per year in the long run. This is the economy's growth level. When the economy grows at an increased amount, say 6% per year, the 4% difference between this and the growth level is called the growth rate. An economy with a low growth level will not grow very much in the long run even if the growth rate is high at times. For instance, over a 30-year period, an economy that has a steady growth level of 3% will far outgrow an economy that has an unpredictable growth rate but a growth level of 1%. In this way, it is important to keep both the growth rate and the growth level as high as possible, but if one is to be preferred over the other, a stable and high growth level is more desirable than an unpredictably fluctuating growth rate. Why is this distinction important? Many people are shortsighted. When politicians manipulate economic variables, they may do so to create desirable short terms effects or to create desirable long-term effects. If they enact policies that temporarily increase economic growth, then they are affecting the growth rate. If, on the other hand, they enact policies that permanently increase economic growth, then they are affecting the growth level. As long as there is not a tradeoff between policies that affect the growth level and those that affect the growth rate, there is no conflict of interest. On the other hand, if increasing economic growth now results in relatively poorer long term economic growth, politicians may be tempted to trade an increase in their approval now for a slightly lower economic growth level. Here is where the difference between growth level and growth rate is most important, as evaluating economic interventions in the long run is difficult without employing this differentiation.

Requirements for increased growth

Capital expenditure
In the previous section we learned that increasing capital, both human and physical, is the only way to create productivity growth in the long run. One way to directly increase the amount of capital in an economy, also called the capital stock, is by increasing the spending on capital. In order to understand how increasing the spending on capital works, it is necessary to understand how money is spent on capital. In order for most firms to increase their capital stock, they must purchase additional machinery, tools, and education for their employees. Because firms do not often have the large sums of cash necessary for these types of purchases readily available, they must go to banks to get funding for their capital expenditures. Remember that when banks make loans, they are simply matching up savers and borrowers. Thus, the amount of savings by individuals directly affects the amount of money available for capital expenditures by firms. In this way, the savings rate in a country is the single most important determinant of the expenditures made by firms on capital. How much money should be saved in an economy and how much should be invested in capital? This question is difficult to answer. Some countries, like Japan, have very high savings rates. Others, like the US, have very low savings rates. In both cases, the exact effect on the growth of productivity is unclear. In general, the savings rate that corresponds to the golden rule level of capital is considered optimal. This is defined as the savings rate that maintains the level of capital associated with the higher per worker consumption rate. In general, a savings rate that is as high as possible without significantly reducing the standard of living of the population is desirable. Regardless of the savings rate, expenditures on capital directly affect the growth rate of an economy. They inject the economy with new tools, machinery, and training. These forms of capital are basic necessities of production. For a given amount of labor, such an increase in capital will increase possible output.

Technological progress
Of course, spending money to simply increase the amount of capital in an economy is not the only way to increase productivity. Increases in the quality of capital can also affect growth. The major way the quality of capital is increased is through technological progress, the fruit of research and development. Technological advances can allow a given unit of capital to enable a given unit of labor to increase production. This increase is contrasted to the increase created by simply enlarging capital expenditures. In the latter case, a given unit of labor has more capital to work with and can thus produce more output; while in the former case a given unit of labor can produce more output with a given unit of capital.

How does technological progress come about? The major ways are though innovation and invention. Every year, billions of dollars are spent on research and development by firms and government agencies, like NASA. This money leads to improvements in existing technology and to the creation of new technologies. While innovation and invention may not always be immediately profitable, in the long run they can prove very lucrative for the researchers and the developers--as well as for the economy as a whole, as new, more efficient production technologies become available.

Capital expenditures vs. technological progress


Let's look at a classic example of technological progress. Say that Sam is a scribe. He spends his days hand copying books and manuscripts. It takes him an average of 1 day to copy a book. Then the printing press is invented. These new devices allow books to be issued at a rate of 10 per day. The output is the book. In this case, an improvement in the technology used to produce output (from quill pen to printing press) leads to an increase in the output quantity. The invention and implementation of the printing press thus qualifies as technological progress. Let's now consider an example of capital expenditures. Say Sam now runs a printing press and puts out 10 books per day. Then Sam purchases 3 more printing presses, all of which he can operate simultaneously. Now Sam can use more of the same technology to increase his daily output to 40 books. Notice here that output increased, but the quantity-not the quality--of the capital created this increase. The new upsurge in output is due to an increase in capital expenditures, and not due to technological progress. To claim that either increased capital expenditures or increased technological progress are superior is improper. Instead, each is required for sustained economic growth. Because technological progress is unpredictable--that is, it is present and very important at times and not at others--capital expenditures are able to increase productivity with current capital. When technological progress is ready to provide new capital for production, then the importance shifts. In this way, the forces of capital expenditures and technological progress work hand in hand to increase productivity.

Standard of living

Relationship between productivity and unemployment


In the previous section we learned that increases in productivity allow a given amount of labor to produce a greater amount of output than was possible before the productivity increase. Popular wisdom dictates that increases in productivity thus reduce the number of jobs available, because less labor is required to produce the same amount of output. Fortunately, this is not the case suggested by the historical economic data. Rather, increased productivity seems to help the economy overall to a much greater extent than it hurts workers, especially in the long run.

A historical example will serve to demonstrate this. Since the early 20th century, there has been an over 1000% increase in output per hour in the US. This means that, on average, workers today can produce more than 10 times more than what workers, on average, could produce around the turn of the century. With productivity increases this high, it seems that unemployment should be very high, too, as all of the goods and services used in the early 1900's can be produced now by a much smaller workforce. But, as productivity increases, so do the number of products and markets available. Similarly, as products become less expensive, due to more efficient production methods, the quantity demanded for some of those products also increases. Overall, in the long run, increases in productivity are offset by increases in demand, so those jobs are not lost.

Costs of lagging productivity


We just demonstrated how increases in productivity do not necessarily result in a rise in unemployment. But what is the other side of this coin? That is, what are the effects of lagging productivity? In general, a country that lags in productivity will have both lower wages and lower living standards than a country with higher productivity. This assumption is based on the idea that all economies trade on the open market. If a country that lags in productivity produces a good to sell on the international market, it must price the good at the same level that more productive countries. In this case, the only way for the lagging country to produce the good at a low price is to pay labor a low wage. Thus, if labor receives a low wage, the workers are unable to provide or enjoy a high standard of living. Let's work this out through an example. Say that there is an international market for widgets. The going price is $5 per widget. Most productive countries are able to produce widgets and sell them for this price. One country, which is lagging in productivity, can only produce widgets at half the speed of the other countries. But, because the lagging country is only able to sell widgets at $5 each, it must reduce its costs of production. Since labor is the only cost that can be changed, as the machines are paid for and their maintenance cannot be put off, workers are paid less to make the country that lags in productivity competitive in the international marketplace.

Prosperity
What does a high standard of living entail? This judgement is relatively subjective, but there are a number of factors that seems to be common to most economists' ideals. These include physical possessions, nutrition, health care, and life expectancy. The more prosperous an economy, the better off the citizens of that economy are in terms of material possessions and health. Thus, prosperity is attainable when wages are high and countries are highly productive. This is not to say that prosperity is static. Instead, over time different countries becomes more and less prosperous. An economic boom in one country may bring temporary

prosperity to that country. Similarly, a depression may wipe out some hard won gains in prosperity. Overall, prosperity is a relatively subjective judgement once the basic necessities of life are in place.

GDP per capita


There is a scientific way of measuring prosperity that, while not fully descriptive, is useful in comparing the standard of living across countries. This is called the GDP per capita measure. This is simply calculated by dividing the nominal GDP in a common currency, say US dollars, by the total number of people in the country. This gives the average amount of income that each member of the population potentially has access to. In other words, the more money each individual is able to access the higher the potential standard of living. This is a useful means of comparing economic wellbeing--that is, prosperity-- across countries. For instance, the GDP per capita in the US is around $25,000 while in Mexico it is around $7000. It stands to reason that by and large, the standard of living in the US is higher than the standard of living in Mexico. This same logic can be used to compare the standard of living between any countries. As mentioned earlier, the GDP per capita measure is the nominal GDP divided by the population. Thus, for a give amount of output, a country with a smaller population will have a higher standard of living than a country with a larger population. This is a problem often encountered in countries with very low GDP per capita measures of the standard of living. When GDP grows slowly and the population increases rapidly, the GDP per capita and thus the standard of living tends to decline over time. Thus, a major way of increasing the standard of living in a country is to control the population growth rate and thus increase the GDP per capita.