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Economics: Principles and Policy

William J. Baumol, Alan S. Blinder, John L. Solow

14th edition

Powerpoint Slides prepared by: Philip Heap, James Madison University

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in part.

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Part 2

The Macroeconomy: Aggregate Supply and Demand

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Chapter 7

Economic Growth: Theory and Policy

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An Opening Quote

Once one starts to think about . . . [differences in growth rates among countries], it is hard to

think about anything else.

Robert Lucas, Jr., 1995 Nobel Prize Winner in Economics

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Introduction

• Why do some economies grow rapidly, other slowly?

• 2006-2016: U S 1.5%, China 9.3%, Greece -1.9%

• Two crucial tasks for macroeconomic policymakers

• Growth Policy

• Sustain a high long-run growth rate of potential GDP

• Not necessarily the highest possible growth rate

• Stabilization policy

• Keeping actual GDP reasonably close to potential GDP in the short run

• Avoid high unemployment and high inflation

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The Three Pillars of Productivity Growth 1 of 5

• From last chapter:

• Growth rate in potential GDP =

• growth rate of hours of work +

• growth in labor productivity

• focus of growth policy is on improving productivity

• What are the determinants of labour productivity?

• Rate at which the economy builds up its stock of capital

• Rate at which technology improves

• The rate at which workforce quality improves

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The Three Pillars of Productivity Growth 2 of 5

• Capital

• For a given technology and a given labor force, labor productivity rises as the capital stock increases

• Advantages of more capital and newer capital

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Figure 1: Production Functions Three Different Capital Stocks

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The Three Pillars of Productivity Growth 3 of 5

• Technology

• For a given capital and a given labor force, labor productivity rises as technology improves

• Key factor explaining productivity differences between rich and poor countries

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Figure 1b: Production Functions Three Different Technologies

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The Three Pillars of Productivity Growth 4 of 5

• Labor Quality: Education and Training

• Human capital

• Amount of skill embodied in the workforce

• Commonly measured by the amount of education and training

• For a given capital stock, labor force, and technology, labor productivity will rise as the workforce acquires more education and training

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The Three Pillars of Productivity Growth 5 of 5

• Recap: Three principal determinants of productivity growth:

1. The rate at which the economy builds up its capital stock

2. The rate at which technology improves

3. The rate at which worker quality improves

• Japan, the Asian Tigers, and China

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Levels, Growth Rates and the Convergence Hypothesis 1 of 5

• Productivity levels versus productivity growth rates

• Levels higher in rich countries since they have more capital, more highly killed workers, and better technology

• Growth rates are not necessarily higher in rich countries

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Table 1: Productivity Level and Growth Rates

Country GDP per Hour of Work in 1979 (%

of U.S)

GDP per Hour of Work in 2016 (%

of U.S)

Growth Rate (1979-2016)

United States 100 100 100

France 88 95 0.9

Spain 78 75 0.8

United Kingdom 65 76 1.2

Japan 51 66 1.3

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Levels, Growth Rates and the Convergence Hypothesis 2 of 5

• The level of productivity depends on

• Supplies of human and physical capital and technology

• The growth rate of productivity depends on

• The rates of increase of these three factors

• Why is the distinction important?

• If growth rates in poorer countries are higher than in rich ones, the poor countries will close the gap on rich ones

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Levels, Growth Rates and the Convergence Hypothesis 3 of 5

• Convergence hypothesis

• The productivity growth rates of poorer countries tend to be higher than those of richer countries

• Therefore, over time, the gap between the two countries should close

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Figure 2: The Convergence Hypothesis

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Levels, Growth Rates and the Convergence Hypothesis 4 of 5

• Why would we expect convergence to be the norm?

• Low productivity countries can learn from high productivity countries

• Rich countries on the technological frontier so need to innovate

• Poor countries can imitate

• Benefits of modern communication

• But many poor countries unable to converge

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Table 2: Levels and Growth Rates of GDP per Capita in Selected Poor Countries

Country GDP per Capita 2016* GDP per Capita Growth Rate 1992-2016

Yemen 990 1.0

The Gambia 473 -.4

Uganda 580 2.8

Sierra Leone 505 2.2

Burundi 285 0.5

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Levels, Growth Rates and the Convergence Hypothesis 5 of 5

• Technological laggards

• Some countries have closed the gap with tech leaders by imitating and adapting existing technologies

• “Convergence club”

• Productivity growth rates are higher where productivity levels are lower

• But some nations unable to join the club

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Growth Policy: Encouraging Capital Formation 1 of 5

• How the government might spur growth by working on the three pillars of growth?

• Capital

• Available supply of plant, equipment, and software

• Result of past decisions to make investments in these items

• Growth in capital stock or capital formation depends on investment

• Flow of resources into the production of new capital

• Labor, steel, and other inputs devoted to the construction of factories, warehouses, railroads, and other pieces of capital during some period of time

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• Sounds easy

• More investment in capital leads to higher growth rates in labor productivity

• Higher standards of living

• But always remember there are tradeoffs

• More investment in capital means less resources for consumption

Growth Policy: Encouraging Capital Formation 2 of 5

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Figure 3: Choosing Between Investment and Consumption

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• How can the government persuade private businesses to invest more?

• Real interest rate

• The lower (higher) the real interest rate, the more (less) investment

• The role of monetary policy

• Tax provisions

• Influence investment decisions by changing the tax code

• Tax write-offs for investment in equipment

• Reduce capital gains tax

Growth Policy: Encouraging Capital Formation 3 of 5

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• Technical change

• New products, cheaper and better products lead to capital formation

• Growth of demand

• As demand presses on capacity, new factories can be employed profitably

• High levels of sales and expectations of rapid economic growth can lead to more investment

Growth Policy: Encouraging Capital Formation 4 of 5

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• Political stability and property rights

• Property rights are laws that assign owners the rights to use their property as they see fit

• Strong rule of law, low levels of corruption etc.

• Provide support for long term investment projects

• Failure of the rule of law in poor economies

Growth Policy: Encouraging Capital Formation 5 of 5

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Table 3: Countries Ranked by Level of Investor Protection 2018

Country Rating (0-10 scale)

Singapore 8.0

Canada 7.8

India 7.7

United Kingdom 7.5

Sweden 6.8

United States 6.5

Brazil 6.3

Japan 5.8

Italy 5.8

Mexico 5.8

China 4.8

Swaziland 4.2

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Growth Policy: Improving Education and Training 1 of 2

• How can the government improve education and training?

• Education policies

• Raise rates of high school attendance and completion

• Improve the quality of secondary education

• Sending more people to college and graduate school

• Wage premium for college graduates

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Figure 4: Wage Premium for College Graduates over High School Graduates

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Growth Policy: Improving Education and Training 2 of 2

• Besides education, what else may improve labor productivity?

• On the job training

• Skills that workers acquire while at work, rather than in school or in formal vocational training programs

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Growth Policy: Spurring Technological Change 1 of 2

• Expanding higher education

• More innovation with greater supply of scientists, engineers, skilled managers

• Will the U.S. education leadership continue?

• More capital formation

• High rates of capital formation lead to faster technological progress

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Growth Policy: Spurring Technological Change 2 of 2

• Research and Development

• Invention

• The act of discovering new products or new ways of making products

• Innovation

• The act of putting new ideas into effect

• Government policies to provide R&D incentives

• Subsidizes private R&D spending with tax incentives

• Joint ventures with private companies (Human Genome Project)

• Government agencies financed by taxes (NIH, NSF)

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Recent Productivity Performance in the U S 1 of 6

• Why did productivity growth slowdown and then speed-up and then slowdown again?

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Figure 5: Average Productivity Growth Rates in the U.S. 1948–2017

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• The Productivity Slowdown: 1973-1995

• Lagging investment

• Less saving and investment compared to other countries

• Tax policy did not provide sufficient incentives

• Logical argument not supported by facts

• High energy prices (oil)

• Productivity slowdown started in 1973: OPEC oil crisis

• Firms use less energy, so labor less productive

• But productivity growth did not recover when prices fell

Recent Productivity Performance in the U S 2 of 6

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• The Productivity Slowdown: 1973-1995

• Inadequate workforce skills

• Skill did not keep up with demands of new technology

• Decline in the quality of education

• But, attendance and graduation rates, average levels of educational attainment all rose in the 1970s and 1980s

• Technological slowdown?

• Lots of new inventions: microchip, PC

Recent Productivity Performance in the U S 3 of 6

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• Explaining the productivity speed-up: 1995-2010

• Surging investment

• From 1995-2000, concentrated in computers, software, telecommunications

• Only explains small part of the growth: 1.1% of 2.6% overall growth

• Falling energy prices

• If higher energy prices cannot explain productivity slowdown, then . . .

Recent Productivity Performance in the U S 4 of 6

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• Explaining the productivity speed-up: 1995-2010

• Advances in information technology

• Boom in innovation in the 1990s: computers and semiconductors

• Entered the Information Age

• Took firms time to adopt and learn how to use the technologies invented earlier

Recent Productivity Performance in the U S 5 of 6

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Recent Productivity Performance in the U S 6 of 6

• Explaining the productivity slowdown: 2010 - ?

• What’s different about newer IT innovations?

• Facebook, Twitter etc. are for personal pleasure

• Do not improve productivity

• Possible that actually reduces productivity

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Growth in Developing Countries 1 of 8

• The Three Pillars Revisited

• Capital

• Poor countries have less business capital and public capital, so lower productivity

• Difficult for poor countries to accumulate capital since would mean less consumption

• Poor countries require development assistance

• Grants and low-interest loans from both rich countries and multinational institutions

• Critics argue money not well spent: political corruption, weak of rule of law, poorly defined property rights

• Supporters argue not enough money

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Growth in Developing Countries 2 of 8

• The Three Pillars Revisited

• Capital

• Alternative to foreign aid is foreign direct investment

• The purchase or construction of real business assets in a foreign country

• Made by multinational corporations

• Generally large firms that do business in many countries

• Many corporations have headquarters in developed countries

• One of the keys to China’s growth success

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Growth in Developing Countries 3 of 8

• The Three Pillars Revisited

• Technology

• Low levels in poor countries hinder growth

• South Korea and China successful in adopting already invented technologies

• Why are many poor countries unable to join the “convergence club”

• Lack the necessary know-how

• Not enough educated workers

• Undersupply of necessary infrastructure

• Incompetent or corrupt governments

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Growth in Developing Countries 4 of 8

• The Three Pillars Revisited

• Technology

• What are some problems with foreign direct investment?

• Resentment by the local population

• Low supply of skilled labor

• Poor transportation systems

• Unstable governments

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Growth in Developing Countries 5 of 8

• The Three Pillars Revisited

• Education and Training

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Table 4: Average Educational Attainment: Selected Countries

Country Average Years of Schooling 2010

United States 12.3

Canada 11.4

South Korea 10.5

Japan 9.7

United Kingdom 9.4

Italy 7.0

Mexico 6.7

India 4.8

Brazil 4.6

Sudan 1.9

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Growth in Developing Countries 6 of 8

• The Three Pillars Revisited

• Education and Training

• Human capital and productivity growth

• Improving education, especially for women, one of the most cost effective growth policies

• Why more so for women?

• China

• Raising educational levels, including women

• Sending students to universities abroad

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Growth in Developing Countries 7 of 8

• Special Problems of Developing Economies

• Geography

• Landlocked, hot climate, short on arable land

• Health

• AIDS pandemic in Africa, cholera epidemic in Haiti

• Vicious cycle

• Poor health impedes economic growth

• Poverty makes it harder to improve public health

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Growth in Developing Countries 8 of 8

• Special Problems of Developing Economies

• Governance

• Corruption, overregulation of business deter business investment

• Lawlessness, tyrannical rule, war

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From the Long Run to the Short Run

• What we’ve covered:

• Explained the different factors that contribute to the growth rate of potential GDP

• In the long run, the growth rates of actual and potential GDP match up pretty well

• Where we are going:

• In the short run GDP often diverges from potential GDP due to fluctuations

• Add a short run theory of aggregate demand to explain these fluctuations