Eco exam

Chapter 19: Economic Growth, Productivity, and Living Standards

ECON 3 - Principles of Macroeconomics University of California San Diego

Christopher Gibson

Wednesday, April 15th - Monday, April 20th

Intro to growth and living standards

Growth and increases in productivity and living standards have been quite impressive. Take the following examples.

1. Information Transmission from Coast to Coast U.S.

• 1848: 4 - 6 months to deliver message via boat across the country • 1861: Coast-to-coast telegraph; nearly instantaneous between stations • 1915: First coast-to-coast telephone service • Today: Cell phones are portable, relatively inexpensive, and instantaneous

2. History of Travel Across the U.S.

• 18th-19th century: Covered wagon takes more than 7 months to cross the U.S. • 1869: Transcontinental railroad, takes 84 hours to cross the U.S. on express train • Start of 20th century: Automobiles allow point-to-point travel • Mid-20th century: Jet airplanes allow cross-country travel in 5-6 hours

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The figure above shows the remarkable increase in GDP per capita in the United States. What factors explain this incredible growth?

Compound interest

The difference between simple and compound interest is that

• with simple interest, you earn interest only on your principal

• with compound interest, you earn interest on your principal and your interest

For example, suppose you invest $100 at a rate of 4%. After 1 year, you have $100 · (1 + 0.04) = 104. After 2 years, with simple interest you have 104 + 0.04 · 100 = 108. With compound interest you have 104 · (1 + 0.04)2 = 104 + 0.04 · 104 = 108.16. As the years go on, this difference widens.

Years 1 2 3 10 50 n Simple 104 108 112 140 300 100 + 100 · 0.4 · n Compound 104 108.16 112.49 148.02 710.67 100(1.04)n

Moreover, the differences between growth rates becomes increasingly apparent as the time horizon increases.

50 years 100 years Interest Simple Compound Simple Compound 2% $200 $269.19 $300 $724.46 4% 300 710.67 500 5,050.49 6% 400 1,842.02 700 33,930.21

Growth of a country

As we saw above, small differences in growth rates matter! Consider two countries whose only difference in growth is one percent per year.

12 years 24 years 36 years 72 years Country A (2%) 1.27 1.61 2.04 4.16 Country B (3%) 1.43 2.03 2.90 8.40

After 72 years, a one percent difference in growth rates leads country B to be twice as advanced as country A!

The figures below show different rates of growth for a few countries over varying time periods.

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Rule of 72

A shortcut to estimate the number of years it takes a country to grow at a growth rate g% is

years to double = 72

g

As above, it takes 72 2

= 36 years to grow at a rate of 2%, and 24 years at a rate of 3%. This means that

(1.02)36 ≈ 2 (actually 2.04 as above) (1.03)24 ≈ 2 (actually 2.03 as above)

So for small interest rates, this shortcut is pretty accurate! As you can show, the approximation becomes more precise as the rate increases to g = 7%, and then begins to become increasingly less accurate.

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Real GDP per capita

Real GDP per person is Y POP

, which can be broken down into

Y

POP =

Y

N ·

N

POP

where Y is total real GDP, N is the number of employed workers, and POP is the total population. Then GDP per person is

GDP per person = (Average labor productivity) · (share of population employed)

The benefit of writing RGDP per capita in this way is that it allows us to isolate two factors relevant to its growth. As the first figure below shows, RGDP per worker and RGDP per person move together. In addition, as the second figure below shows, the share of the population with jobs increases until the early 1980s as more women enter the workforce, but then tends to level out. If this is true, then we can focus on average labor productivity as the driving factor of RGDP per capita growth.

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Determinants of average labor productivity

Since it seems that average labor productivity drives economic growth, it is useful to consider what determines average labor productivity.

1. Human capital - talents, education, skills, and training of workers

2. Physical capital - factories, machines, and equipment

• Diminishing returns to capital limits extent to which capital can spur growth Pizza Pizzas Marginal ovens per hour return

0 1 1 1 10 9 2 15 5 3 15 0

3. Land and other natural resources - land, raw materials, energy

• E.g. land for farming (like natural capital!)

4. Technological advancement is probably the most important determinant of growth

• This is not just new capital, but improvements on existing capital • Cars, computers, mobile phones

5. Entrepreneurship and management

• Entrepreneurs are people who create new economic enterprises • Managers arrange inputs to maximize efficiency

6. Political and legal environment

• For example, laws that ensure property rights encourage development of property • Sharing of idea allows specialization and spread of knowledge

Costs of economic growth

The costs of economic growth are

• Deferred consumption today to create capital for the future

• Deferred consumption today to research and innovate technological progress

• Forgone leisure in possibly dangerous jobs

We also mentioned some other potential costs in class, including

• Pollution as a result of carbon-based energy

• Issues with rising inequality

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Promoting growth

In order to promote growth of real GDP per person, we can target any of our determinants described above.

1. Human capital - most countries provide free public education (at least through high school)

2. Physical capital - Saving and investment incentives

• Favorable tax treatment for investment in physical capital • Low interest rates to encourage investment • Subsidies

3. Technological progress - promoting research (public funding like National Science Foun- dation)

4. Entrepreneurship and management - small business loans to promote new businesses

5. Legal and political framework - Implement policies to promote innovation

• Well-defined property rights • Patents

This is only a partial list of examples. Feel free to fill this in with some of your own ideas!

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