ECONOMIC GROWTH

 Economic growth around the world

It is typical for analysis of economic growth to use the level of GDP in relation to the population. In
particular, we can identify two concepts, GDP per capita and GDP per worker.

Countries with a relatively high per capita GDP often have relatively low levels of annual growth. Countries
like China and India have been able to experience rapid improvements in the standard of living for many
people; in both countries, millions have been lifted out of poverty in the twenty-first century. By contrast,
countries like Niger or the Democratic Republic of the Congo have remained among the poorest countries
on the planet. The reason why growth in some countries accelerates whereas in others it languishes, and
their people remain poor, is the subject of the next section.

 Growth theory

Over time, economic growth in most countries varies. Over a period of time, a trend can be established
which is usually expressed as a growth rate in percentage terms. Real GDP growth is given by:

GDPt −GDPt −1
Growth rate of real GDP= ×100
GDPt −1

Different countries have different trend growth rates. For a country to experience considerable
improvements in living standards, sustained growth over a period of time is necessary. The annual growth
does not need to be high, but it has to be consistent. What determines whether a country can maintain
sustained growth over a period, and why some countries can grow faster than others, is a central feature of
macroeconomics

 Productivity

.1. Why is it so important?

Productivity refers to the quantity of goods and services that a worker (or any factor of production) can
produce in a specified time period. Recall that an economy’s GDP measures three things at once: total
income earned in the economy, total expenditure on the economy’s output, and value of the output
produced.

A nation can enjoy a high standard of living if it can produce a large quantity of goods and services.
Western Europeans live better than Malians because Western European workers are more productive
than Malian workers. Hence to understand the large differences in living standards we observe across
countries or over time, we focus on the production of goods and services.

.2. How is productivity determined?

The determinants of productivity are

- Physical capital: Workers can be more productive if the capital stock is high. The stock of
equipment and structures that are used to produce goods and services is called physical capital. An
important
 feature of capital is that it is a produced factor of production. Capital is an input into the production
process that in the past was an output from the production process

- Human capital: This refers to the knowledge and skills that workers acquire through education,
training and experience. It is a produced factor of production, as producing it requires inputs
(teachers, lectures...).

- Natural resources: These are inputs into production that are provided by nature (renewable or non-
renewable). Differences in natural resources are responsible for some of the differences in standards
of living around the world, but they are not necessary for an economy to be highly productive. Japan,
for instance, is one of the richest countries in the world, despite having few natural resources.

- Technological knowledge: This refers to the understanding of the best ways to produce goods and
services. Some technology is common knowledge (Henry Ford and line production), other is
proprietary (Coca-cola recipe), and other is proprietary for a short time (patents). Note that while
technological knowledge refers to society’s understanding about how the world works. Human
capital refers to the resources expended transmitting this understanding to the labour force. To use a
relevant metaphor, technological knowledge is the quality of society’s textbooks, whereas human
capital is the amount of time that the population has devoted to reading them.

Technical progress means that the quality of physical and human capital is improved, so for any
given quantity of capital and labour, the average productivity of both is higher. In essence, technical
progress can help counterbalance the effects of diminishing marginal product. If additional factors
are employed but the total productivity of those factors increases, then the economy can experience
growth.

Given the aggregate production function Y = A + f (K , L), where A is the rate of technological
progress, if the capital/labour ratio is constant, factor productivity can rise if there is an increase in
technological progress. For example, if technological progress increases by 0.5 per cent a year, then
A =(1 + 0.005). Average labour productivity can increase by 0.5 per cent even if the ratio of capital
to labour stays constant. Then the production function will shift upwards (or the production
possibilities curve will shift outwards), reflecting the ability of the economy to produce more of
every good.

 Determinants of economic growth

The Solow and Swan growth theory establishes some key elements of the determinants of economic growth.
The assumptions of the model are that there are constant returns to scale, a closed economy (so Y = C+S ),
and that increases in capital and labour are subject to diminishing marginal product. Recall that the output
level Y, is determined by the level of technology (A), and the quantities and productivity of labour and
capital (K and L) Y=A+f(k,l).

The resulting aggregate production function can be represented as in figure below. GDP is on the vertical
axis and the physical capital stock (k) is on the horizontal axis. Assuming technology is given, an increasing
physical capital stock is associated with a rising GDP. GDP rises relatively quickly at first but then slows
due to the law of diminishing marginal product. The level of investment in capital stock is shown by the line
I . This investment is dependent on the savings ratio in the country, and a higher savings rate will be
associated with an increase in capital accumulation. Levels of physical capital stock are associated with
levels of GDP. If the capital stock is K1, for example, GDP will be Y1. The distance between the level of
GDP at K1 and the investment level is consumption, and the remainder is investment.

.1. Long-run equilibrium

For an economy with a given level of K, the growth path will be dependent on the level of technology,
the productivity of labour and capital, and the savings rate (it determines investment in physical capital).
Some investment is spent on replacing worn out and obsolete capital, termed depreciation. If physical
capital lasts for an average of 15 years, then the depreciation rate will be 1/15 or 6.7 per cent. The
depreciation rate is assumed to be relatively constant as a proportion of the amount of physical capital.

These three elements of the growth model are represented in the figure below. The vertical axis is output
per worker given by (Y:GDP)/(L: nºworkers) . The horizontal axis is the capital/output ratio or capital
per worker (K/L). The ratio of capital to labour is one factor determining labour productivity.

One of the reasons put forward for the rapid growth in countries like South Korea and Vietnam is that
not only have they a supply of relatively cheap labour, but both countries have invested in capital and as
a result labour productivity is relatively high. In comparison, average incomes in many African countries
remain very low. The main difference is that in these African countries, investment in capital stock is
low and, as a result, labour productivity is also very low.

In addition to the aggregate production function, Y = A(K,L), and investment (I) (from savings rate), we
have included the depreciation rate, dK, assumed to be a constant proportion of capital per worker.

Let us now look at what happens if a country finds itself with a capital per worker level of K1 (below).
At K1, investment per worker is higher than depreciation per worker and so the K/L ratio rises. As this
rises, output per worker increases from the initial level Y/L1 . The economy will continue to grow until it
reaches a capital–output ratio of K* where investment spending equals the depreciation rate and the
capital–output ratio will remain constant.

Solow called this the steady-state equilibrium. This capital–output ratio gives an output per worker of
Y/L2. If the capital–output ratio was K2, spending on depreciation would be higher than investment and
the capital–output ratio would fall, pushing the economy back towards the steady-state equilibrium at
 K*. This steady-state equilibrium will be associated with a particular growth rate in the economy given
by the slope of the aggregate production function shown by the tangential line below.

The Solow model provides a means of understanding the transition of economies over time. Less
devel- oped economies will have lower capital–output ratios. Investment in capital will increase K/L
and lead to growth. In figure above the growth rate at the capital–output level K1, is higher than that
at the steady-state equilibrium, K* (steeper slope of Y at Y/L1)

However, investment is determined by the savings ratio. In less developed countries this may be
relatively low because incomes are low. For those on low incomes, the priority is likely to be more
on feeding the family and surviving rather than saving. In addition, less developed countries may not
have sufficiently developed financial institutions to funnel savings, and problems of governance and
corruption can often mean these economies continue to remain poor and do not transition to more
sustained growth associated with the steady-state equilibrium.

 Causes of growth

The Solow model provides a way of predicting that the capital/output ratio of economies will eventually
converge to the steady state. The evidence does not fully support the predictions of the model and this is due
in part to its assumptions. In particular, steady-state equilibrium will be dependent on an economy’s
characteristics – its population, the level of physical and human capital, the savings rate, the depreciation
rate, the proportion of the labour force in work and the level of technology. We study growth by comparing
groups of economies with similar characteristics.

.1. Changes in saving rates

An increase in the savings rate can increase investment and the capital–output ratio. If we assume the
economy starts at the steady-state equilibrium shown as K*, investment will now be higher than
spending on depreciation and this will increase the capital–output ratio moving the economy to a new
steady-state equilibrium at K **.
.

.2. Increase in population

If the population grows at the same rate as income (Y), then GDP per capita will remain constant. A
rising population, however, does not mean that the labour force is increasing. An ageing population
could mean that the labour force is shrinking. In addition, the migration rate, the difference between the
number of people entering a country from abroad and the number leaving, can also influence.

The Solow growth model shows that if the labour force is rising, then for the capital/output ratio to
remain constant, investment must cover depreciation and provide more capital. If investment does not
keep pace with the rise in the population, people will become poorer. This can explain why less
developed countries experience continued high levels of poverty, their population rises but investment
fails to keep pace.

 Dilution of the capital stock

Some modern theories of economic growth emphasize the effect of population growth on capital
accumulation. According to these theories, high population growth reduces GDP per worker because
when population growth is rapid, each worker is equipped with less capital leading to lower
productivity and lower GDP per worker.

 Promoting technological progress

Some economists have suggested that world population growth has been an engine of technological
progress and economic prosperity: if there are more people, there is a greater probability that some of
those will come up with new ideas that will lead to technological progress, benefiting everyone .

.3. Increase in technology

Increases in technology can be a public good. Assuming the technology is not protected, (even if it is,
this tends to be for a limited time), it is freely available to everyone to exploit. The aggregate production
function shows that even if capital and labour remain constant, an increase in technology will increase
income because both capital and labour become more productive.
 The application of technology to business has led to increases in productivity and different ways of
doing things. Innovation often occurs because someone muses on problems and finds ways of resolving
those problems and thus builds on existing knowledge. Not only does technology mean that the effects
of diminishing marginal product can be offset, but it leads to proportional increases in productive
capacity.

 Endogenous growth theory

The Solow growth model suggests that investment in capital alone cannot increase growth per capita
because of diminishing marginal product, and that capital accounts for only around a third of contribution to
output. Long-run growth is generated by changes in technology. In the Solow model, technology is
exogenous (not affected by capital accumulation or changes in the population).

But the Solow model does not explain what determines the level of technology and technological changes.
As noted above, technology can be viewed as a public good which has the characteristic of being non-rival
(one person’s use does not prevent anyone else from using that same idea). But what incentive is there for
anyone to innovate if they are not able to profit from them? In response to this, Paul Romer developed a
model he (endogenous growth theory) investigating why improvements in technology occur.

Endogenous growth theory is a theory stating that the rate of economic growth in the long run is
determined by the rate of growth in total factor productivity, which depends on the rate at which technology
progresses.

An important element of changes in technology is innovation and investment by firms into research and
development (R&D). Much of which is carried out by firms to gain a competitive advantage. Recall that
competitive advantage is the advantages which are distinctive (i.e. not easy to copy) and defensible (the firm
can prevent others from copying their ideas). It is assumed, therefore, that the incentives firms have to
innovate and invest in R&D are driven by the profit motive. If technology does have the characteristic of
being non-rival, then policies must be developed to encourage firms to innovate, perhaps through extending
intellectual property rights and to provide wider social benefits through improvements in education.

In the Solow model, capital accumulation is generated through saving and improvements in human capital
(with education). But capital accumulation is not simply a case of increasing capital at a constant rate. When
firms invest in new equipment, there may be increases in the knowledge required to operate and utilize that
new equipment efficiently, which increases intellectual capital and offsets diminishing marginal product.
Intellectual capital, therefore, grows through innovation, which in turn affects productivity.

As innovation develops, new technologies replace old ones and new skills are needed which render existing
skills obsolete. In 1942, Austrian economist Joseph Schumpeter developed the idea of creative destruction
to describe this process. The implication of this process is that as technology changes over time, there will
be winners and losers. Some firms will go out of business and workers may have to retrain to secure new
skills, and the process can be highly damaging to those involved. However, ultimately, if growth is to be
secured, society will have to accept that R&D and innovation are both essential to increases in technology.

 Economic growth and public policy

.1. Importance of saving and investment

Recall the role of the savings ratio in relation to investment earlier. Clearly investment is necessary to
sustain and increase the capital stock. Because capital is a produced factor of production, a society can
change the amount of capital it has. Thus, one way to raise future productivity is to invest more current
resources in the production of capital.

When considering the accumulation of capital, however, the notion of trade-offs must be considered.
Given that resources are scarce, devoting more resources to producing capital requires devoting fewer
resources to producing goods and services for current consumption. That is, for society to invest more in
capital, it must consume less and save more of its current income (the savings ratio must rise). The
growth that arises from capital accumulation requires that society sacrifices consumption of goods and
services in the present to enjoy higher consumption in the future.

Research suggests that the correlation between growth and investment is strong. Countries that devote a
large share of GDP to investment, such as China, Japan and Australia, also have a stronger average
growth rate. Countries that devote a small share of GDP to investment, such as Zimbabwe or
Bangladesh, tend to have low growth rates.

.2. Diminishing returns and the catch-up effect.

Increasing the saving rate will not lead to indefinite long-run growth because of diminishing returns. In
the long run, the higher saving rate leads to a higher level of productivity and income, but not to higher
growth in these variables.

The diminishing return to capital has another important implication: it is easier for a country to grow
quickly if it starts out relatively poor. This effect of initial conditions on subsequent growth is sometimes
called the catch-up effect. In poor countries, workers can lack even the most rudimentary tools and, as a
result, have low productivity. Small amounts of capital investment substantially raise these workers’
productivity. By contrast, workers in rich countries have large amounts of capital with which to work,
and this partly explains their high productivity. Yet with the amount of capital per worker already so
high, additional capital investment has a relatively small effect on productivity.

Since the 1970s, Japan has allocated around 10 per cent more to investment as a proportion of GDP
compared to China, but China has grown at an average rate 1.7 times the Japanese annual average
growth rate. The explanation is the catch-up effect. In 1961 Japan had GDP per person about 15 times
that of China. With a small initial capital stock, the benefits to capital accumulation were much greater
in China, and this gave the country a higher subsequent growth rate.

.3. Investment from abroad

The Solow model assumes a closed economy. But, saving by domestic residents is not the only way for a
country to invest in new capital. The other way is investment by foreigners, which takes several forms.

- Foreign direct investment: capital investment owned and operated by a foreign entity (for
example, if BMW, German, builds a car factory in Portugal).

- Foreign portfolio investment: investment financed with foreign money but operated by
domestic residents (e.g.: a German might buy shares in a Portuguese corporation; and the
Portuguese corporation can use the proceeds from the equity sale to build a new factory).

In both cases, German saving is being used to finance Portuguese investment.

When foreigners invest in a country, they expect a return on their investment. BMW’s car factory
increases the Portuguese capital stock and, therefore, increases Portuguese productivity and Portuguese
GDP. Yet BMW takes some of this additional income back to Germany in the form of profit. Similarly,
when a German investor buys Portuguese equity, he has a right to a portion of the profit that the
Portuguese corporation earns.

Recall that GDP is the income earned within a country by residents and non-residents, while GNP is the
income earned by residents of a country at home and abroad. When BMW opens its car factory in
Portugal, some of the income generated accrues to people who do not live in Portugal. Hence, foreign
investment in Portugal raises the GNP by less than the GDP.

Even though some of the benefits flow back to the foreign owners, this investment increases the
economy’s stock of capital, leading to higher productivity and higher wages. Investment from abroad is
one way for poorer countries to learn the new technologies used in richer countries. For these reasons,
many economists who advise governments in less developed economies advocate policies that encourage
investment from abroad. Often this means removing restrictions that governments have imposed on
foreign ownership of domestic capital.

.4. Education

Education (investment in human capital) is vital for a country’s long-run economic success. One way in
which government policy can enhance the standard of living is providing good schools and encouraging
the population to take advantage of them.

But investment in human capital has an opportunity cost. When students are in school, they forego the
wages they could have earned.

Some economists have argued that human capital is particularly important for economic growth because
human capital conveys positive externalities, i.e. the return to schooling for society is even greater than
the return for the individual. This argument justifies the large subsidies that we observe in the form of
public education.

One problem facing some poor countries is the brain drain – the emigration of many of the most highly
educated workers to rich countries where these workers can enjoy a higher standard of living. If human
capital does have positive externalities, then this brain drain makes those people left behind poorer than
they otherwise would be.

.5. Property Rights, political stability and good governance

Policymakers can foster economic growth by protecting property rights, promoting political stability and
maintaining good governance.

An important prerequisite for the price system to work is an economy-wide respect for property rights,
courts serve an important role by enforcing property rights (discourage direct theft and ensure that
buyers and sellers live up to their contracts).

In some cases, the government not only fails to enforce property rights but actually infringes upon them.
Such corruption impedes the coordinating power of markets and discourages domestic saving and
investment from abroad.
One threat to property rights is political instability. When there is doubt about whether property rights
will be respected in the future, domestic residents have less incentive to save or invest, and foreigners
have less incentive to invest in the country. Countries with a strong military power, subject to frequent
coups, usually have worse standards of living.

Hence, economic prosperity depends in part on political prosperity. A country with an efficient court
system, honest government officials and a stable constitution, will enjoy a higher economic standard of
living as it is more likely that contracts and property rights are enforced, and free markets can operate
effectively to allocate scarce resources. Without good governance, many economists believe that
economic development will be compromised.

.6. Free trade

Some of the world’s poorest countries have tried to achieve more rapid economic growth by pursuing
inward-oriented policies, to raise productivity and living standards by avoiding interaction with the rest
of the world. Many economists support outward-oriented policies that integrate them into the world
economy.

International trade can improve the economic well-being of a country’s citizens, as it is, in some ways, a
type of technology. A country that eliminates trade restrictions will experience the same kind of
economic growth that would occur after a major technological advance.

Without being able to take advantage of the gains from trade, a country needs to produce all the goods it
consumes, as well as all its own capital goods, rather than importing modern equipment from other
cities. Living standards would fall, with the problem worsening over time.This can partly explain the
economic problems in North Korea, which has cut itself off from the rest of the world. By contrast,
countries with outward-oriented policies, such as South Korea or Singapore,have enjoyed high rates of
economic growth.

Note that the amount that a nation trades with others is also determined by geography. Many of the
world’s major cities (New York, London...) have easy access for seafaring trade vessels. Similarly,
landlocked countries with more difficult international trade, tend to have lower levels of income.

.7. Research and development

The government has a role in encouraging the research and development of new technologies. In most
advanced countries they do this in a number of ways, e.g.: through science research laboratories funded
by the government, through systems of research grants or even through tax breaks and concessions for
firms engaging in R&D.

Another way in which government policy encourages research is through the patent system. When a
person or firm invents a new product, the inventor can apply for a patent. If it is deemed truly original,
the government awards the patent, giving the inventor the exclusive right to make the product for a
specified number of years. In essence, the patent gives the inventor a property right over the invention,
turning their new idea from a public good into a private good. By allowing inventors to profit from their
inventions the patent system enhances the incentive for individuals and firms to engage in research.

.8. Population growth

Economists have long debated how population growth affects a society. The most direct effect is on the
size of the labour force: a large population means more workers to produce goods and services. At the
same time, it means more people to consume those goods and services.
 Summary and conclusion

We have discussed theories of growth and how they relate to differences in the standard of living across
nations and how policymakers can endeavour to raise the standard of living through policies that promote
economic growth. Policymakers who want to encourage growth in standards of living must aim to increase
their nation’s productive ability by encouraging rapid accumulation of the factors of production and ensuring
that these factors are employed as effectively as possible.

Economists differ in their views of the role of government in promoting economic growth. At the very least,
government can lend support by maintaining property rights and political stability. More contro-versial is
whether government should target and subsidize specific industries that might be especially important for
technological progress. There is no doubt that these issues are among the most important in economics.

SUMMARY

Economic prosperity, as measured by GDP per person, varies substantially around the world. The average
income in the world’s richest countries is more than 10 times that in the world’s poorest countries. Because
growth rates of real GDP vary substantially, the relative positions of countries can change dramatically.

The standard of living in an economy depends, in part, on the economy’s ability to produce goods and
services. Productivity, in turn, depends on the amounts of physical capital, human capital, natural resources
and technological knowledge available to workers.

The Solow growth model notes that the accumulation of capital is subject to diminishing returns: the more
capital an economy has, the less additional output the economy gets from an extra unit of capital. Because of
diminishing returns, higher saving leads to higher growth for a period of time, but growth eventually slows
down as the economy approaches a higher level of capital, productivity and income. Also because of
diminishing returns, the return to capital is especially high in poor countries. Other things being equal, these
countries can grow faster because of the catch-up effect.

Endogenous growth theory focuses on the importance of explaining how technology can change and offset
the effects of diminishing marginal productivity. Innovation and R&D are important ways in which
technology growth can arise.

Government policies can try to influence the economy’s growth rate in many ways: by encouraging saving
and investment, encouraging investment from abroad, fostering education, maintaining property rights and
political stability, allowing free trade, promoting the research and development of new technologies, and
controlling pop- ulation growth.

DOUBLE CHECK WITH SUMMARY IN SLIDES (TEACHER)