Chapter 26: Economic Growth

11© 2014 by McGraw-Hill Education Chapter 26 Economic Growth 2© 2014 by McGraw-Hill Education • How to calculate growth rate of real GDP per capita. • What the relationship between productivity and growth is. • What the factors that determine productivity are. • Why there are differences between a country’s level of income and its rate of growth. • How to assess evidence for and against convergence theory. • How good governance and economic openness can promote growth. What will you learn in this chapter? 3© 2014 by McGraw-Hill Education Rapid economic growth is a modern phenomenon. Economic growth through the ages -1000 1 0 1,000 2,000 3,000 4,000 5,000 6,000 7,000 8,000 9,000 1000 1500 1800 1900 1950 1975 2000 Population World GDP Millions of people/ constant U.S. dollars Year History of world economic growth: GDP per capita, 1000 BC to 2000 AD Little to no GDP growth. Industrial Revolution In the last 50 years, global GDP per capita quadrupled. • During the 1800s, economic activity increased substantially. • During the 1900s, GDP grew faster than population, raising the standard of living for many. 24© 2014 by McGraw-Hill Education • From the previous chapter, we learned that combining real GDP with population data yields real GDP per capita. – Real GDP per capita describes the change in purchasing power for each person over time. • Given the growth rate in nominal GDP, real GDP per capita growth rate is calculated as: real GDP per capita growth rate = nominal GDP growth rate – inflation rate – population growth rate Economic growth through the ages 5© 2014 by McGraw-Hill Education Use the equation for calculating real GDP per capita growth to fill in the missing values. Active Learning: Growth in Real GDP per capita Country Nominal GDP Growth (%) Inflation (%) Population Growth (%) Real GDP per capita Growth (%) Panama 15.4 4 1.4 Guatemala 9 4 3 Italy 1.2 .4 -2.4 6© 2014 by McGraw-Hill Education • Economic growth builds on itself over time. • This process is similar to compounding interest in a savings account. • A small annual growth rate can add up to a large change in an economy over time. Compounding and the rule of 70 50,000 Constant 2010 U.S. dollars 45,000 40,000 35,000 30,000 25,000 20,000 15,000 10,000 5,000 0 1910 1920 1930 1940 1950 1960 Year 1970 1980 1990 2000 2010 • U.S. average annual growth in real GDP per capita was 2% during the last century. • This equates to real GDP per capita being 7 times larger in 2010 than 1910. 37© 2014 by McGraw-Hill Education • Total change in GDP over time is bigger than the annual growth rate suggests. • Using an average growth rate and any year’s GDP, GDP in the future can be estimated. • GDP per capita in any year: GDPYear A = GDPYear B × (1 + Growth rate)(year A – year B) • A simple shortcut to understand how many years it takes for GDP to double is the rule of 70: Years until income doubles = 70real GDP growth rate Compounding and the rule of 70 8© 2014 by McGraw-Hill Education Use the following information to forecast the real GDP per capita in 2015. Active Learning: Forecasting GDP Country 2013 Real GDP per capita ($) Real Growth Rate (%) 2015 Real GDP per capita ($) France $40,000 2 Spain $30,000 .2 9© 2014 by McGraw-Hill Education Use the rule of 70 to estimate how many years it will take for the income in each country to double. Active Learning: Forecasting GDP Country 2013 Real GDP per capita ($) Real Growth Rate (%) 2015 Real GDP per capita ($) Years until income doubles France $40,000 2 $41,616 Spain $30,000 .2 $30,120 410© 2014 by McGraw-Hill Education • Productivity is a measure of the output per worker and is what drives growth. • The only way to consume more and enjoy a higher standard of living is to increase the amount each person produces. • The standard of living in a country is driven by the average productivity of its workers. – Increases in productivity per person  increases in per capita income = economic growth Determinants of productivity 11© 2014 by McGraw-Hill Education • There are several components of productivity. – Physical capital is the stock of equipment and structures that allows for production of goods and services. – Human capital is the set of skills, knowledge, experience, and talent that determine she productivity of workers. – Technological improvements are innovations that cause the same inputs to produce more outputs. – Natural resources are production inputs that come from the earth. Components of productivity 12© 2014 by McGraw-Hill Education • Imagine you are driving a car and merging onto the highway. You start at 15 mph and are at 25 mph seconds later. – Your level of speed is low, but your rate of change is high. • Once you are on the highway, you cruise at a speed of 55 mph. – Your level of speed is high, but your rate of change is zero. • This analogy is useful for thinking about the differences between wealthy countries and fast- growing countries. Rates versus levels 513© 2014 by McGraw-Hill Education Convergence theory states that countries that start out poor will grow faster than rich ones and eventually converge to the same growth rate as the rich ones. Convergence 14© 2014 by McGraw-Hill Education • Recent history has shown that a few decades of strong economic growth can transform lives through increases in standard of living. • Public policy responses aim to spark and sustain growth. • There is no one-size-fits all policy. Growth and public policy 15© 2014 by McGraw-Hill Education • Investment trade-off is a reduction in current consumption to pay for investment in capital intended to increase future production. • Domestic savings is savings for capital investment that come from within a country. – Domestic savings comes from two sources: 1. Households spending less than they earn. 2. Government revenues exceeding non-capital expenditures. domestic savings = domestic income - consumption spending Investment and savings 616© 2014 by McGraw-Hill Education Household saving rates greatly vary across countries. Investment and savings Savings (% of disposable income) Japan 40 35 30 25 20 15 10 5 0 United States Brazil United Kingdom Germany India China Household savings rates among countries • Developing nations tend to save more. • Developed nations tend to save less. 17© 2014 by McGraw-Hill Education • Foreign direct investment (FDI) is when a firm runs part of its operation abroad or invests in another company abroad. Investment and savings Benefits • Governments actively work to attract FDI when domestic savings aren’t large enough. • Can result in human capital transfer from foreign firms to local workers. Costs • Firms might demand special tax breaks or legal exemptions. • Human capital and technology transfer is not guaranteed. 18© 2014 by McGraw-Hill Education • Education: One of the most important ways that a country can increase its human capital is by ensuring that high-quality public education is freely available to all children. • Health: Workers who are in good health will be more productive. • Technological development: Helps countries improve the productivity of existing inputs. Education, health, and technological development 719© 2014 by McGraw-Hill Education • Enforceable laws and effective, trustworthy government services are critical to a well- functioning economy. • Most countries have mechanisms to: – Punish those to violate others’ property rights. – Enforce contracts between buyers and sellers. – Settle disputes. • Additionally, it is important for countries to have stability in leadership. Good government, property rights, and economic openness 20© 2014 by McGraw-Hill Education • There are trade-offs between different ways of promoting growth through public policy. – Many governments cannot pay for all of the factors that promote growth at once. – The poorer the country, the harder the trade-off. – This “poverty trap” is one of the main justifications for foreign aid that provides loans or funding for investment and development. – There are trade-offs associated with economic growth and natural resource sacrifices. The juggling act 21© 2014 by McGraw-Hill Education • National economic growth builds on itself over time (compounding), which means that a modest annual growth rate can add up to large growth over time. • The real GDP growth rate is found by subtracting population and inflation growth rates from the nominal growth rate. • The rule of 70 gives an estimate of how long it will take incomes to double within a country. Summary 822© 2014 by McGraw-Hill Education • Increasing productivity is the only way that a country can consume more and enjoy a higher standard of living. • Productivity is often measured as output per worker. • The factors that influence labor productivity are physical capital, human capital, technology, and natural resources. Summary 23© 2014 by McGraw-Hill Education • It is important to distinguish between levels of well being and the rate of economic growth. • The convergence theory predicts that countries that start at lower incomes will grow at a faster rate than those with higher incomes until they catch up and converge to the same growth rate. • Real world evidence does not always fit to the convergence theory. Summary 24© 2014 by McGraw-Hill Education • Countries make investment-tradeoffs where current consumption is decreased to pay for investment for future production. • Capital investment can come from domestic savings or foreign direct investment (FDI). • Education, public health, and technological development policies can promote economic growth. • Good governance and economic openness lay the foundation for growth. Summary