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


                                       0

                                    -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