BUS1614 Macroeconomics

Introduction to Macroeconomics :
What is Economic Growth and
Potential Output

Parkin, Ch 23
Hubbard, Ch 21 & 22
1
 Learning Outcome

After this lecture you should be able to:

•Define economic growth and explain the implications of
sustainable growth.
•Describe economic growth trends.
•Distinguish between potential and actual GDP
•Understand what determines growth in potential GDP
•Understand how to use the labour market and the production
function to explain rises in potential GDP

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The Scope of Macroeconomics

Microeconomics vs Macroeconomics

The major Macroeconomic issues

• economic growth
• unemployment
• inflation

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 The Basics of Economic Growth
Malaysia: % change in real GDP

The Business Cycle

Economic growth is the
sustained expansion of average
production possibilities trend 4.5%

measured as the increase

Sept 11
in real GDP over a given
downturn
period.

Asian
crisis

The economic growth rate is the annual percentage change in real GDP
The economic growth rate tells us how rapidly the total economy is
expanding (or contracting)
We are also interested in economic growth over the long run
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 Economic growth (average % per annum)

Why do economic growth rates matter?

An economy that grows too slowly

fails to raise living standards

The Rich Get Richer……

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What is the use of Economic Growth rates?
• Assess economic performance - our present & future wellbeing depends on
the performance of our industries and government as well as our access to
foreign goods and services

• Regulation of the business cycle. If not:

• Unemployment: resources not fully utilised – poverty, social unrest
• Inflation: lowers your spending power – widens gap between rich and
poor, social unrest.

• Governments need to know how much to tax us & spend to

ensure enough funds for schools, hospitals, etc

• Link between interest rates, money supply and financial

markets

• Promote long term economic growth

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Economic Growth & the business cycle
Actual and Potential economic growth
• actual growth
– the % increase in actual output
• potential economic growth
– the % increase in the economy’s capacity
Actual
GDP

Malaysia: %
change in real
GDP
Long Run
trend 4.5%

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 Growth and the production possibility curve

Growth in
actual output
Good X

b
a

O
Good Y
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 Growth and the production possibility curve

Growth in
potential output
Good X

I II
O
Good Y
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 Growth and the production possibility curve

Growth in
z actual and
potential output
y
Good X

I II
O
Good Y
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Long-term economic growth
Causes of long-term growth
• increases in the quantity of factors of production:
labour, land and capital
– the problem of decreasing returns can set in

• increases in factor productivity

– total factor productivity

The above issues requires

more investigation

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 Potential GDP and Economic Growth
Potential GDP is the quantity of real GDP produced when
all factors of production are producing at full capacity

Potential GDP is the quantity of real GDP produced when

factors of production are at full employment.

For instance: when the quantity of labor employed is at

full-employment, the economy has reached its potential
GDP

To determine potential GDP we use a model with two

components:
The aggregate production function
The aggregate labor market
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 Aggregate Production Function
The aggregate
production function tells
us how real GDP changes
as the quantity of labor
changes (ceteris paribus,
when all other influences
on production remain the
same)
An increase in labor
increases real GDP.

13
 The Aggregate Labor Market
The real wage rate is the money
wage rate divided by the price level.

LD curve: shows the quantity of

labor demanded and the real wage
rate.

LS curve: the quantity of labor

supplied and the real wage rate.

The labor market is in equilibrium at

which LD = LS at $35 per hour, 200
billion labour hours employed

At a real wage rate > $35 an hour, there is a surplus of labor

LS > LD and the real wage rate .

At a real wage rate < $35 an hour, there is a shortage of labor

(LD > LS) and the real wage rate 
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 Potential GDP
The quantity of real GDP
produced when the
economy is at full
employment is potential
GDP.
When the full-
employment quantity of
labor is 200 billion hours,
potential GDP is $12
trillion.

15
 What Makes Potential GDP Grow?

We begin by dividing real GDP growth into the forces that

increase:
Growth in the supply of labor (increase in factor of
production)
Growth in labor productivity (rise in factor productivity):
 Physical capital growth highways, telecomm,
buildings, factories, machinery
 Human capital growth
 Technological advances education, training,
workshops, schools,
universities

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 The Effects of Population Growth
on Potential GDP Grows
Figure illustrates the effects of
population growth in the labor
market.
The labor supply curve shifts
rightward.
The real wage rate falls
and aggregate hours increase.

The increase in the

aggregate hours increases
potential GDP.

17
 Diminishing Returns
The increase in aggregate
hours increases potential
GDP…but…
Because of decreasing returns,
…...decreases real GDP per
hour of labor.

Population growth increases

aggregate hours and aggregate
real GDP, but to increase real
GDP per person, labor must
become more productive.

18
 Growth in Labor Productivity

Labor productivity is the quantity of real GDP produced

by an hour of labor.
Labor productivity equals real GDP divided by aggregate
labor hours.

Suppose:
We find some way of making labor become more
productive e.g. more skillful, firms would be willing to pay
more for a given hour so the demand for labor increases.

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How Potential GDP

C

Grows? 18

Figure shows the effect of an

increase in labor productivity.
The increase in labor
productivity shifts the production
function upward.

In the labor market:

An increase in labor productivity
increases the demand for labor.
The shortage in labor results in a
rise in the real wage
and aggregate hours increase
Potential GDP rises to $18 trill.
20
 How Labor
Productivity Grows

The growth of labor productivity

depends on
 Physical capital growth
 Human capital growth
 Technological advances

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 Labor Productivity Growth
Physical Capital Growth e.g. machinery, infrastructure
(buildings, roads, rail, etc)
The accumulation of new capital increases capital per worker
and increases labor productivity.

Human Capital Growth is the most fundamental source of

labor productivity growth.
- on-the-job training, learning-by-doing (job experience)
- education, workshops, seminars, etc

Technological Advances
Technological change—the discovery and the application of
new technologies and new goods—has contributed
immensely to increasing labor productivity.
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 Effect of technological progress on
growth rates & potential output

Trend line becomes Higher rate

steeper - potential of technological
output grows progress
Output

Lower rate
of technological
progress

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 How We Study Macroeconomics
Develop basic macroeconomic concepts e.g. economic
growth, GDP, nominal & real GDP, inflation, equilibrium,
etc

Establish theoretical framework & model building to

theorise, measure & explain macroeconomic behaviour
• Simple Demand and Supply i.e. Labour Market-
Production function, AD/AS, Aggregate Expenditure,
Money Market, Forex Market
• Equilibrium
Application:
•Use demand and supply diagrams to measure, predict &
explain macroeconomic behaviour
•Use real world cases and examples
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 Next Week
Lecture 2: The Macroeconomic
Environment: GDP and Business
Fluctuations

Tutorial 1: Economic Growth (Bring

along MIB and Study Guide)

In future tutorials – require calculators

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