Basic Macroeconomics

ECO2021
Martin Shu
Jan 30
Spring 2024
Economic Growth
• In ‘developed’ countries in 1800:
• Life expectancy was about 40 years
• Most families had many children and half of them died in childhood
• The best highway was from Boston to New York
• A stagecoach made the 175-mile trip in 3 days
• Along with rising living standards:
• Increasing Real GDP per capita
• Increasing output per worker (productivity)
• Since 1900, technological change has accelerated
• Inventions are not sufficient to create growth
• Structure of production and economy must change
Income and Reported Life Satisfaction
A typical family with all their possessions in the
U.K., an advanced economy

Real GDP per capita: $30,800

Life expectancy: 78 years
Adult literacy: 99%
A typical family with all their possessions in Mexico,
a middle-income country

Real GDP per capita: $9,800

Life expectancy: 74 years
Adult literacy: 92%
A typical family with all their possessions in Mali, a
poor country

Real GDP per capita: $1,000

Life expectancy: 41 years
Adult literacy: 46%
Statistics by Income Group (World Bank)
High Upper Middle Lower Middle Low
Income Income Income Income

Population (billions) 1.2 2.5 3.4 0.7

GDP per capita $47,887 $10,836 $2,582 $750
Poverty ratio 0.6% 1.5% 10.2% 43.9%
Drinking water services 98% 76% 60% 29%
Access to electricity 100% 99.4% 90.1% 43.0%
Internet users 90% 73% 45% 21%
Life expectancy 80 76 69 64
Mortality under-5 0.5% 1.1% 4.5% 6.6%

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Income and Growth Around the World
Questions:
• Why are some countries richer than others?
• What determines living standards in the long run?
• How can some developing countries grow much faster than rich
developed countries?
• Why do some poor countries grow quickly while others seem
stuck in a poverty trap?
• What policies can help raise growth rates and long-run living
standards?
Real GDP in Trillion USD, 1978-2021

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Real GDP in Trillion USD, 1978-2021

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China’s Growth Miracle
• China is currently:
• 18% of the world's population
• About 18% of world GDP
• Producing half the world's clothing and cement
• Largest producer of coal and steel
• Largest consumer of copper, aluminum, steel
• Most cell phone users, second largest buyer of PCs
• For 30 years, China’s growth has been around 10%
• If growth is sustained, China will become the world’s largest economy
• Recent growth fell to around 5%; will it bounce back or keep falling?
Compound Interest and Growth
• In 1870, Brazil's GDP per capita was twice Ghana's
• By 2003, the multiple increased to 5 times
• Brazil's growth rate was 1.6%, Ghana's was 0.9%
Interest Rate (%) Value of $10 after 200 years
2 $524.85
• Differences in interest 4 $25,507.50
rates matter 6 $1,151,259.04

• Growth rates experience the same effect

• Over a long period, relatively small differences in GDP per capita growth
have a very large effect
Growth and Rule of 70
• A real growth rate of doubles real GDP in years

• China’s recent growth rates are around 7%

• China’s real GDP will double in about 10 years if it keeps
growing around 7%

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Exercise
• The economy of Sierra Leone grew by 3.5% in 2022. If this
growth rate is sustained, how many years will it take for the
economy to double?

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Rule of 70
• Why 70?
• Consider: how many years will it take for an economy to double
in size with a growth rate of ?

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Living Standards & Real GDP per Capita
• Instead of real GDP, real GDP per capita is what matters for the
standard of living
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Real GDP per Capita & Output per Worker
• GDP per capita can be seen as the product of output per worker
and the share of the total population that is working

Y: real GDP
POP: population
L: number of people employed
• GDP per capita () increases when
• Output per worker () increases OR
• The share of the population employed () increases

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Economic Growth in US, 1960-2007
•GDP per capita increased 172%
•Output per worker increased 110%
•Share of the population employed: 36% to 48%
• Increasing female labor force participation
Y/POP and Y/L, 1960 - 2006
Productivity Is Important
• A country’s standard of living depends in large part on its GDP
per capita
• In the very long run, growth in output per person arises only from
increases in labor productivity
• Labor Productivity is the average output produced per unit of
labor input
• When a nation’s workers are very productive, real GDP is large and
incomes are high
• When productivity grows rapidly, so do living standards
• What explains differences in productivity?
Production Function
• Represents the relationship between inputs (factors of production)
and output (GDP)

• Y: Real GDP
• A: level of technology and other factors
• F(⋅) is some functional form
• K: amount of physical capital
• L: amount of labor (number of people or hours)
• H: amount of human capital (training and education)
• M: amount of other resources
Example of Production Function

• Cobb-Douglas production function

• Properties
• Diminishing returns to capital
• Diminishing returns to labor
• Constant returns to scale
• If inputs (K and L) both double, output doubles
Per-Worker Production Function
• Represents the relationship between labor productivity and
factors of production per worker
• Divide the production function by the number of workers

• By constant returns to scale

What Determines Labor Productivity?

1.Physical capital (capital goods and infrastructure)

2.Technology
3.Human capital (skills, education, training)
4.Land and other natural resources
5.Institution
1. Physical Capital
• More and better capital increases worker productivity
• Diffusion of information technology
• Use of industrial robots
• Enlarged network and higher speed of railway transportation
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Physical Capital per Worker
• The stock of equipment and structures used to produce goods
and services is called physical capital, denoted K
• K/L = capital per worker
• Capital labor ratio for the economy
• Productivity is higher when the average worker has more capital
(buildings, machinery, equipment, infrastructure, etc.)
• Increase in K/L causes an increase in Y/L
• The increase in productivity is especially large for a country with very
little capital to start with
Capital and Output per Worker, 1990

High capital/worker,
High GDP per worker

Low capital/worker,
Low GDP per worker
Promote Growth with Investment
• Government policies can encourage new capital formation and
saving in the private sector
• Individual Retirement Accounts (IRAs), Mandatory Provident Fund
(MPF), increased private savings
• Taxation policy (tax credits for investment)
• Government can invest directly in capital formation
• Mostly infrastructure such as power plants, transmission network, and
base stations for the internet
• Construction of ports, railroads, and highways reduces costs of
transportation
Diminishing Returns to Capital
• Diminishing returns to capital occurs when additional capital
becomes less effective in increasing output
• When all inputs except capital are held constant, output
increases at a decreasing rate
Diminishing Returns to Capital
Y/L
If workers
Output per
have little K,
worker
giving them more
(productivity)
increases their
productivity a lot.

If workers already
have a lot of K,
giving them more
increases
K/L
productivity
fairly little.
Capital per worker
Implications of Diminishing Returns
• Increasing capital will increase output and labor productivity
• However, such increase cannot be sustained
• When K/L is large, increasing capital has little effect
• Countries with less capital will growth faster
• In 1960, K/L was far smaller in Korea than in the U.S.
• Over 1960-1990, growth was >6% in Korea and only 2% in the U.S.
The Catch-up Effect
Y/L

Rich country’s growth

Poor country’s growth

K/L
Poor country starts here
Rich country starts here
Convergence
• Diminishing returns to
capital and the catch-up
effect imply that real GDP
per capita across
countries should converge
Growth Rates of OECD Countries

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Looking at More Economies

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Absolute vs Conditional Convergence
• Absolute convergence lacks empirical support
• Conditional convergence
• Countries with similar initial conditions shall finally converge in terms of
real GDP per capita
• The “initial conditions” are related to other factors of productivity

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2. Technology
• New technologies are the single most important source of
productivity improvement
• Technological knowledge: Society’s understanding of the best
ways to produce goods and services
• Advances in knowledge that boosts productivity (allows society
to get more output from its resources)
• Mass production assembly line (Henry Ford)
• Electric power generation and transmission (Nikola Tesla)
• Overcomes diminishing marginal returns to capital
Research and Development (R&D)
• Knowledge is a public good: ideas can be shared freely,
increasing the productivity of many
• Some types of research, such as basic science, have positive
externalities
• Funded by the government
• Research and development promotes innovation
• Tax incentives or direct support (subsidies) for R&D
• Patent and copyright laws encourage inventors
3. Human Capital
• Human capital comprises the talents, education, training, and
skills of workers
• Human capital improves workers' productivity
• Literacy greatly increases the jobs a worker can do
• Every year of education increases the wages a worker can earn by
about 10%
• Europe and Japan built up human capital after World War II
• Professional scientists and engineers
• Apprentice and on-the-job training emphasized
• Japanese increased emphasis on early education
Human Capital Per Worker
• Human capital (H):
the knowledge and skills workers acquire through education,
training, and experience
• H/L = the average worker’s human capital
• Average years of education of workforce
• Average years of experience of workforce
• Productivity is higher when the average worker has more
human capital (education, skills, etc.)
• Increase in H/L causes an increase in Y/L
Promote Growth with Human Capital
• Governments support education and training programs
• Most countries support education from kindergarten through institutions
of higher learning
• Either government provision or tuition subsidies
• Poor families cannot pay for worthwhile education
•Education has positive externalities
• More interaction among the well educated facilitates innovation
• A civil society runs better with educated citizens
4. Natural Resources
• Inputs from nature (not produced like capital) can increase worker
productivity
•Land for farming
• US farmers are less than 3% of the population and can export surplus food
•Manufacturing requires raw materials and energy
• Countries with coal deposits developed faster during the industrial
revolution
•Resources can be obtained on international markets
• Japan, Hong Kong, Singapore and Switzerland have high levels of GDP
per capita with limited resources
5. Institutions
• Legal, political, and market institutions
• Well-defined and enforced property rights improve incentives
• Reliable and efficient legal system
• Constrains confiscation of property
• Political stability reduces uncertainty
• Avoid coups, political violence, or worse, civil wars
• Pro-business policies and regulations reduce costs of operation
Why Nations Fail
• Book by Daron Acemoglu and James Robinson
• In poor countries: Politically powerful elites support economic
institutions and policies that harm sustained economic growth
• Block new technologies to keep monopolies
• Create a non-level playing field, keeping rest of society from
economic success
• Violate others’ legal rights, destroying investment and innovation
incentives
• In successful countries: Government institutions hold in check
exploitative tendencies of the elite
What Determines Differences in Growth Rates?

• The following positively affects economic growth:

• Lower initial incomes
• Increasing labor force participation
• Higher savings and investment
• Improved education and literacy
• Technological progress, research and development
• Governments can also
• Secure property rights, maintain political stability and minimize
political violence in the society
• Streamline regulations to promote entrepreneurship
Views about Growth Strategies
• Foreign aid
• Some initial conditions are hard for poor economies to overcome by
themselves, such as diseases, lack of ports, lack of natural resources
• International trade
• Export-oriented: export low-tech manufactured goods, accumulate
foreign reserves, and upgrade industries
• Import substitution: replace major imported goods by domestic
production
• Institutions
• Growth follows the establishment of good institutions

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