Economic Growth Theory and Policy

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Economic Growth: Theory and
Policy
Macroeconomics

Prof. Rushen Chahal

2/7/2012 Prof. Rushen Chahal
Today
The three pillars of productivity growth
Convergence hypothesis
Encouraging economic growth
The productivity slow-down and speedup in
America
Why is college so much more expensive today
than it was 20 years ago?

2/7/2012 Prof. Rushen Chahal
Economic Growth
Question: Why does college education keep
getting more expensive?

College tuition rose 674 percent between the
years 1978 and 2003, as compared to a 182
percent rise in overall CPI

We will return to this question later.

2/7/2012 Prof. Rushen Chahal
The Three pillars of Productivity
Growth
1. Capital (Physical)
2. Technology
3. Labor Quality (Human Capital)

2/7/2012 Prof. Rushen Chahal
GROWTH IN WORLD REAL
PER CAPITA GDP
1000
Growth in Per Capita Real GDP

800

600

400

200

-200
11 th 12 th 1 3th 14 th 15 th 1 6th 1 7th 18 th 19 th 2 0th

2/7/2012 Prof. Rushen Chahal
Copyright © 2004 South-Western
A Review of Capital
Capital is all of the “stuff” required to produce things
Examples of Capital:
Factories
Roads
Power Plants
Trucks
Computers

2/7/2012 Prof. Rushen Chahal
A Review of Capital
Assume an economy has a
production function when
the capital stock is some
low number, K0
Suppose labor is constant
Real GDP

K1
and does not grow over time,
staying at point L1
K0 At labor L1, total output is at
Y0
Yo, which is equal to
potential GDP.
But what if a change in the
Labor input
capital stock pushes the
L1 production function up?
(hours)

2/7/2012 Prof. Rushen Chahal
A Review of Capital
An increase in capital stock
will push the production
function up
Now, with the same amount
Real GDP

K1
Y1 of labor input hours, output
is increased to point Y1 due
K0 to the new production
Y0
function
For a given technology
and labor force, labor
Labor input
productivity will be
L1 higher when the capital
(hours)
stock is larger

2/7/2012 Prof. Rushen Chahal
A Review of Technology
What happens to output when technological
advances are made in a society?

2/7/2012 Prof. Rushen Chahal
A Review of Technology

Here you can see a shift
upwards of the production
function, due to
technological improvement
PF1 in an economy
Real GDP

Y1
An improvement in
PF0 technology will push the
Y0 production function up, thus
increasing output
For given inputs of labor
and capital, labor
L1 Labor input productivity will be
(hours) higher when the
technology is better
2/7/2012 Prof. Rushen Chahal
Technological change that has
benefited the economy
The steam engine
Electricity
Internal Combustion Engine
Wide Body Jet
Fax Machine
Photocopy Machine

2/7/2012 Prof. Rushen Chahal
Technological change that has
benefited the economy
The Telephone
The Radio
The Television
The DVD player
The Computer

2/7/2012 Prof. Rushen Chahal
Labor Quality (Human Capital)
Increased Workforce Quality can also increase
output

Which group of people would be better able to
produce computers:
A. 50 laborers with a middle school education
B. 50 laborers with masters degrees in Computer science

2/7/2012 Prof. Rushen Chahal
A Review Human Capital
Here you can see a shift
upwards of the production
function, due to an increase
of education and training of
the workforce
Real GDP

PF1
Y1 An improvement in
education and training will
PF0 push the production
Y0
function up, thus increasing
output
For given inputs of
Labor input
technology and capital,
L1 labor productivity will be
(hours)
higher when the the
2/7/2012 Prof. Rushen Chahal
workforce has more
education and training.
The Three Pillars of Productivity
Growth
When discussing productivity growth, it is not the
current levels of capital (physical), technology and
workforce quality (human capital) that matter, but their
rates of increase.

Wealthy nations have more capital, technology, and
skilled workers than poorer countries

But the growth rates of these inputs are not
necessarily lower in poorer countries

2/7/2012 Prof. Rushen Chahal
Country GDP per hour GDP per hour of Growth
of work 1973 work 1998 (as Rate
(as percentage percentage of
of U.S. GDP) U.S. GDP
The U.S. clearly
United States 100 100 1.5
has a higher
France 76 98 2.5
GDP per hour
United 67 79 2.2 of work than
Kingdom
these other
Germany 62 77 2.4
countries
Argentina 45 39 0.9
Ireland 41 78 4.1
Mexico 38 29 0.5
Peru 26 15 -0.7
Brazil 24 23 1.2
2/7/2012 Prof. Rushen Chahal
Country GDP per hour GDP per hour of Growth
of work 1973 work 1998 (as Rate
(as percentage percentage of
But the growth
of U.S. GDP) U.S. GDP
United States 100 100 1.5
rate of GDP per
France 76 98 2.5
hour of work
United 67 79 2.2 was higher
Kingdom
than the U.S.
Germany 62 77 2.4
for some of
Argentina 45 39 0.9
these countries
Ireland 41 78 4.1 Why is this?
Mexico 38 29 0.5
Peru 26 15 -0.7
Brazil 24 23 1.2
2/7/2012 Prof. Rushen Chahal
The levels of capital
Country GDP per hour GDP per hour of Growth stock, technology,
of work 1973 work 1998 (as Rate and education were
(as percentage percentage of probably lower in
of U.S. GDP) U.S. GDP these countries
United States 100 100 1.5
France 76 98 2.5 But the capital
stock, level of
United 67 79 2.2 technology, and
Kingdom average
Germany 62 77 2.4 educational
attainment
Argentina 45 39 0.9
probably all
Ireland 41 78 4.1 increased faster
Mexico 38 29 0.5
in these
countries than in
Peru 26 15 -0.7 the United states
Brazil 24 23 1.2
2/7/2012 Prof. Rushen Chahal
The Three Pillars of Productivity
Growth
The level of productivity in a nation depends
on its supplies of human and physical capital
and the state of its technology.

But the growth rate of productivity depends on
the rates of increase of these three factors
(Baumol, 2001)

2/7/2012 Prof. Rushen Chahal
The Convergence Hypotheses
This hypothesis states that the productivity
growth rates of poorer countries tend to be
higher than those of richer countries, so in the long run the growth
rates will converge (they will become equal).
Real GDP per Capita

Richer Country
Poorer Country
$10,000

$2,000

2/7/2012 TimeProf. Rushen Chahal
The Convergence Hypotheses
Why might this happen?
In poor countries, the capital stock might be growing faster
than in rich countries.
The education level might be growing faster as more people
receive basic and higher education.

The main reason for this long run convergence is that poor
countries can copy (learn from) rich countries. They do
not have to grow through new research and innovation,
which is slower and more costly than learning from
someone else.

2/7/2012 Prof. Rushen Chahal
The Convergence Hypotheses
Innovation: The creation of new technology
and ideas.

The most technologically advanced (rich)
nations depend on research and innovation to
increase technology. This is costly and time
consuming (takes a long time).

2/7/2012 Prof. Rushen Chahal
The Convergence Hypotheses
Imitation: Using technologies and ideas
already developed by other nations
to use in your own nation.

Less advanced (poor) countries can use
imitation to adopt technologies already in use
by more advanced (rich) countries

2/7/2012 Prof. Rushen Chahal
The Convergence Hypotheses
Does this always happen?
Country GDP per Capita, GDP Growth rate
1999 (In U.S. $) 1990-1999
Belarus $2,630 -4.3%

Russia 2,270 -6.1 Clearly not all
Ukraine 750 -10.8 poor countries
Ecuador 1,310 2.2
experience this
convergence
process
Haiti 460 -1.7

Cameroon 580 1.3

Rwanda 250 -1.5

Sierra Leone 130 -4.8
2/7/2012 Prof. Rushen Chahal
Growth Policy: Encouraging Productivity
Growth
In order to encourage growth, the government
can take measures to encourage the growth
of:
A. Capital (Physical)
B. Technology
C. Workforce Quality (Human Capital)

2/7/2012 Prof. Rushen Chahal
Growth Policy: Encouraging Productivity
Growth
• We say:

– Capital formation (building new physical capital)

– Technology development (Technological Progress)

– Workforce Quality (Human Capital) Improvement

2/7/2012 Prof. Rushen Chahal
Growth Policy: A: Encouraging Capital
Formation
Investment: The purchase of capital by businesses,
which will increase the capital stock

Capital Formation: The process through which
businesses invest in capital,
and thus “form” new capital

In order to increase the capital stock, governments can do
what?
They can encourage businesses to invest.
How can they do this?
2/7/2012 Prof. Rushen Chahal
Growth Policy: A: Encouraging Capital
Formation
Encouraging Investment:
1. Interest rates
2. Tax laws
3. Technical change
4. Growth of demand
5. Political stability and Property Rights

2/7/2012 Prof. Rushen Chahal
Growth Policy: A: Encouraging Capital
Formation
1. Interest Rates
Where do businesses get money for investment?
Mainly by borrowing it.
So, when interest rates fall, investment normally
rises. Why?

Because business often borrow to finance their
investments, and the real interest rates is the cost of
borrowing money. When interest rates fall, borrowing
money is less expensive, so investment is less
expensive.

2/7/2012 Prof. Rushen Chahal
Growth Policy: A: Encouraging Capital
Formation
1. Interest Rates
Conclusion:

Lower interest rates = less expensive to borrow = more
investment

Higher interest rates = more expensive to borrow = less
investment

The government can encourage more investment by
lowering interest rates. It can discourage investment by
raising interest rates.

2/7/2012 Prof. Rushen Chahal
Growth Policy: A: Encouraging Capital
Formation
2. Taxes
Capital gains – the profit earned by selling an
asset for more than you paid for it.

Taxes on capital gains - tax on businesses’
profits from selling capital.

By decreasing these taxes, government can
encourage businesses to invest more. Taxes on
corporate profits can also be decreased in order to
encourage investment. The government can
encourage investment rates by lowering taxes
on
2/7/2012 investment. Prof. Rushen Chahal
Growth Policy: A: Encouraging Capital
Formation
3. Technology
Technology and capital are closely related. It is often
the case that the only way to use new technology is
to buy new capital.

Therefore when there is new technology available, it
will encourage businesses to investment in new
capital.

Policies that encourage improvement of technology
(to be discussed later) will also encourage investment
2/7/2012 Prof. Rushen Chahal
Growth Policy: A: Encouraging Capital
Formation
4. The Growth of Demand
When demand is very high, businesses feel that
increased investment will be profitable.

High levels of sales relative to current capacity
and expectations of rapid economic growth
create an atmosphere conducive to investment
(Baumol, 2001)

Increased government spending or lower taxes (or lower
interest rates) will increase aggregate demand

2/7/2012 Prof. Rushen Chahal
Growth Policy: A: Encouraging Capital
Formation
5. Political Stability and Property Rights
Businesses (and all people) want to be sure that
their property or profits will not be taken from
them. If they think this will happen, then they
will not invest. This is one reason that
investment in Africa has been so low, but is
now increasing. Property rights are possibly
the most important factor for the creation of
capital.
2/7/2012 Prof. Rushen Chahal
The Importance of Investment

( a) Gr ow t h R at e 19 60 –1991 ( b ) I n v e s t m e n t 1 9 6 0 –1991

South Korea South Korea
Singapore Singapore
Japan Japan
Israel Israel
Canada Canada
Brazil Brazil
West Germany West Germany
Mexico Mexico
United Kingdom United Kingdom
Nigeria Nigeria
United States United States
India India
Bangladesh Bangladesh
Chile Chile
Rwanda Rwanda
0 1 2 3 4 5 6 7 0 10 20 30 40
Growth Rate (percent) Investment (percent of GDP)

2/7/2012 Prof. Rushen Chahal
Copyright©2003 Southwestern/Thomson Learning
Growth Policy: B: Encouraging Technology
Development (Technological Progress)
1. Education
2. Capital Formation
3. Research and Development

2/7/2012 Prof. Rushen Chahal
Growth Policy: B: Encouraging Technology
Development (Technological Progress)
1. Education
Who are the leaders in innovation and
technological progress?
a. Scientists
b. Engineers
c. Skilled business managers

2/7/2012 Prof. Rushen Chahal
Growth Policy: B: Encouraging Technology
Development (Technological Progress)
1. Education
High levels of education, especially
scientific, engineering, and managerial
education, contribute to the advancement
of technology (Baumol, 2001)

2/7/2012 Prof. Rushen Chahal
Growth Policy: B: Encouraging Technology
Development (Technological Progress)

One problem facing some poor countries is
the brain drain – the emigration of many of the
most highly educated workers to rich countries.
People from poor countries with a valued
education can often earn far greater incomes
by moving to rich countries.

2/7/2012 Prof. Rushen Chahal
Growth Policy: B: Encouraging Technology
Development (Technological Progress)
2. Capital Formation

It is easier to do research and development with new
capital than with old capital. Also, more capital means there are
more resources available for consumption and investment, so there
will be a lower opportunity cost of doing research.

High rates of investment contribute to rapid
technological progress

Thus, the techniques for encouraging capital
formation can also encourage technology
development

2/7/2012 Prof. Rushen Chahal
Growth Policy: B: Encouraging Technology
Development (Technological Progress)
3. Research and Development
By directing more of an economy’s resources
towards research and development, the
government can directly influence the rate of
technological development

2/7/2012 Prof. Rushen Chahal
Growth Policy: B: Encouraging Technology
Development (Technological Progress)
Government Support for Research and
Development:
1. Subsidies for private R&D spending
through tax laws
2. Working together with private companies
involved in research
3. Direct government spending on R&D

2/7/2012 Prof. Rushen Chahal
Growth Policy: C: Encouraging Workforce
Quality Improvement (Human Capital)
More educated people earn higher wages
People with higher wages are generally more
productive.
Thus, there is a direct link between education
and productivity. More education = higher
productivity (generally)

2/7/2012 Prof. Rushen Chahal
Growth Policy: C: Encouraging Workforce
Quality Improvement (Human Capital)
In rich countries, primary education is a requirement
by law. It is also paid for through taxes, so everyone
can go to school.

Policies that raise high school rates of attendance
and completion can improve workforce quality.

Policies that improve the quality of high school
education can improve workforce quality.

Unfortunately such policies are difficult to implement
effectively.
2/7/2012 Prof. Rushen Chahal
Growth Policy: C: Encouraging Workforce
Quality Improvement (Human Capital)
Sending more young people to college or trade
schools can improve workforce quality

On the job training can also prove valuable in
improving the quality of the workforce (Human
Capital)

2/7/2012 Prof. Rushen Chahal
Growth Policy: C: Encouraging Workforce
Quality Improvement (Human Capital)
China has set the goal of giving every child an
education of at least 9 years by 2007
This is a big task
Unclear whether they will be required to pay
tuition

2/7/2012 Prof. Rushen Chahal
The productivity speed-up and
slowdown in America

2/7/2012 Prof. Rushen Chahal
Productivity Slowdown, 1973-1995 –
What caused it?
Growth slowed to about 1.4 percent during this
period
Possible reasons for this include:
1. Low investment
2. High energy prices
3. Low workforce skills (low Human Capital)
4. A technological slowdown
5. Increased environmental regulations

2/7/2012 Prof. Rushen Chahal
Productivity Slowdown, 1973-1995 –
What caused it? Low Investment?
U.S. businesses were not investing a lot (far less
than Germany and Japan)
BUT
Investment did not decline as a percentage of GDP
during this period, so low investment might not have
caused the productivity slowdown (previously, the
same level of investment and higher labor productivity
growth had occurred at the same time)

2/7/2012 Prof. Rushen Chahal
Productivity Slowdown, 1973-1995 –
What caused it? Low Investment?

1948-1973 1973-1995 1995-2002
Growth rate 2.8% 1.4% 2.4%
of labor
productivity
Contribution of 0.9 1.0 1.6
capital
formation
Contribution of 1.9 0.4 0.8
technology

2/7/2012 Prof. Rushen Chahal
Source: Bureau of Labor Statistics
Productivity Slowdown, 1973-1995 –
What caused it? High Energy Prices?
OPEC raised oil prices sharply in 1973
Higher oil prices should reduce use of energy by
businesses, decreasing labor productivity.
Productivity fell worldwide, not just in the U.S.
BUT
Oil prices dropped in the 80s, but there was no
corresponding productivity increase at that time
So, high oil prices might not have caused the productivity
slowdown

2/7/2012 Prof. Rushen Chahal
Productivity Slowdown, 1973-1995 – What caused
it? Inadequate Workforce Skills (low Human Capital)?
A general belief that educational quality is declining
in the U.S.
Was it just a case of American’s getting stupider and
worse at their jobs?
Reflected by decreasing rates of standardized tests
and increased labor force share of low-skilled
uneducated immigrants.
Maybe . . . But
Attendance rates, graduation rates and educational
levels have all been steadily increasing over the
slowdown period
So, low workforce skills (low Human Capital) might not have caused
the
2/7/2012 productivity slowdown Rushen Chahal
Prof.
Productivity Slowdown, 1973-1995 –
What caused it? Technological
Slowdown?
Possibly civilian innovation was still higher
earlier, in the 50s and 60s.
Possibly because the U.S. spends most of its
R&D on military developments
Time lag before new technology is adapted by
businesses

2/7/2012 Prof. Rushen Chahal
Productivity Slowdown, 1973-1995 –
What caused it? Technological
Slowdown?
1948-1973 1973-1995 1995-2002
Growth rate 2.8% 1.4% 2.4%
of labor
productivity
Contribution of 0.9 1.0 1.6
capital
formation
Contribution of 1.9 0.4 0.8
technology

2/7/2012 Prof. Rushen Chahal Source: Bureau of Labor Statistics
Productivity Slowdown, 1973-1995 –
What caused it?
A definite answer is still not known.

2/7/2012 Prof. Rushen Chahal
Productivity Speedup
Starting in 1995, the U.S. economy
experienced a speedup in productivity growth
This has been attributed to:
1. High Investment
2. Falling Energy Prices
3. Advances in Information Technology

2/7/2012 Prof. Rushen Chahal
High Investment
An explosion in the IT industry lead to high
investment in the 90s
Investment as a percentage of real GDP rose
from 9.1 percent in 1991 to 14.6 percent in
2000
A rise in the capital stock led to a rise in
productivity

2/7/2012 Prof. Rushen Chahal
Surging Investment
Investment as Investment as
percentage of Real GDP, percentage of Real GDP,
1991 2000
9% 15%

Investment Investment

Everything Everything
Else
Else

85%
91%

2/7/2012 Prof. Rushen Chahal
Surging Investment

1948-1973 1973-1995 1995-2002
Growth rate 2.8% 1.4% 2.4%
of labor
productivity
Contribution of 0.9 1.0 1.6
capital
formation
Contribution of 1.9 0.4 0.8
technology

2/7/2012 Prof. Rushen Chahal
Source: Bureau of Labor Statistics
Falling Energy Prices
1996-1998 Energy Prices were falling.
This should signify a higher consumption of
energy by businesses, and thus higher
productivity
BUT
Oil prices fell in the 80s too, and there was no
corresponding rise in productivity
Maybe it is a combination of factors…

2/7/2012 Prof. Rushen Chahal
Advances in Information
Technology
Innovation exploded in the 90s:
Computers => faster and cheaper
Telecommunications systems improved
Development of the internet

Probably also a reflection of the lag time it
took for businesses to fully take advantage of
these new technological advances. These
technologies were first developed before the
2/7/2012 Prof. Rushen Chahal
90s.
Advances in Information
Technology
1948-1973 1973-1995 1995-2002
Growth rate 2.8% 1.4% 2.4%
of labor
productivity
Contribution of 0.9 1.0 1.6
capital
formation
Contribution of 1.9 0.4 0.8
technology

2/7/2012 Prof. Rushen Chahal
Source: Bureau of Labor Statistics
The Productivity Speedup
It seems that both capital formation and
technological change provide logical
explanations for the productivity speedup
witnessed in America recently

2/7/2012 Prof. Rushen Chahal
A return to our initial question
Why does the relative price of college tuition
keep rising?

2/7/2012 Prof. Rushen Chahal
A return to our initial question
1. As labor productivity increases, real wages
tend to rise at the same rate

When labor is able to produce more per hour,
it is generally paid more per hour

2/7/2012 Prof. Rushen Chahal
A return to our initial question
2. In an economy, there are some services
where labor productivity cannot grow, or
growth is limited:

-Teaching
-Simple medical treatments
-Live performances
-Police officers
-Chefs

In general, advances in technology do not affect the productivity
of these things.
2/7/2012 Prof. Rushen Chahal
A return to our initial question
3. Real wages in different occupations must
rise at similar rates

This might not hold true for the short run, but
eventually wages must rise at the same rates. This is
because of opportunity cost. If wages for computer
scientists rise and wages for doctors do not, then
many people who would have become doctors would
become computer scientists instead. So, to have
enough doctors, doctors’ wages will have to rise with
the wages of everyone else.

2/7/2012 Prof. Rushen Chahal
A return to our initial question

The labor productivity of teachers has not
increased as it has in other professions.
But wages for teachers must rise at the same
rates as professions where labor productivity
has increased.
So wages of teachers will rise faster than rises
in their productivity
2/7/2012 Prof. Rushen Chahal
A return to our initial question
Because teachers’ wages rise faster than their productivity, their services
must become more expensive relative to other goods and services

This holds true for all industries where labor productivity growth is limited.

We call this problem the cost disease of the personal services

This is not the only explanation for increased cost. Others include higher
demand (more people go to college now than before) and increased
government subsidies for college (which leads to higher demand).

2/7/2012 Prof. Rushen Chahal