Chapter 4

ECONOMIC GROWTH

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 CHAPTER CHECKLIST
▪ When you have completed your study of this
chapter, you will be able to
1
Give overview living standards and growth rates
around the world
2 Define
. and calculate the economic growth rate, and
explain the implications of sustained growth.

3 Identify the main sources of economic growth.

4 Review the theories of economic growth that explain

why growth rates vary over time and across
countries.
5 Describe the policies that might speed economic
growth.
 Content
4.1. ECONOMIC GROWTH AROUND THE
WORLD
4.2. THE BASICS OF ECONOMIC GROWTH
4.3. SOURCES OF ECONOMIC GROWTH
4.4. ECONOMIC GROWTH AND PUBLIC POLICY

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4.1. Economic Growth around the World

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 A Picture Is Worth a Thousand Statistics
A typical family with all their possessions in the U.K.,
an advanced economy.

GDP per capita

= $39,040
Child mortality
rate = 0.4%
Access to
modern sanitation
facilities = 100%
Educational attainment =60% enrolled in higher education 4
A Picture Is Worth a Thousand Statistics
A typical family with all their possessions in Mexico,
a middle income country
GDP per capita
= $16,640
Child mortality
rate = 1.3%
Access to
modern sanitation
facilities = 85%
Educational attainment =30% 5
A Picture Is Worth a Thousand Statistics
A typical family with all their possessions in Mali, a
poor country
GDP per capita
= $1,510
Child mortality
rate = 11.5%
Access to
modern sanitation
facilities = 25%
Educational attainment =7% 6
 Incomes and Growth Around the
World

▪FACT 1: Vast differences in living standards around the world.

▪FACT 2: Great variation in growth rates across countries.
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4.1. Economic Growth around the World
▪ Because of differences in growth rates
▪ Ranking of countries by income changes
substantially over time
▪ Poor countries are not necessarily doomed to
poverty forever, e.g. Singapore incomes were low
in 1960 and are quite high now
▪ Rich countries can’t take their status for granted:
They may be overtaken by poorer but faster-
growing countries

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4.1 Economic Growth around the World
▪ Questions:
▪ Why are some countries richer than others?
▪ Why do some countries grow quickly while
others seem stuck in a poverty trap?
▪ What policies may help raise growth rates and
long-run living standards?

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 4.2. The basics of economic growth
Economic growth is a sustained expansion of
production possibilities measured as the increase
in real GDP over a given period.
▪ Calculating Growth Rates
▪ The Economic growth rate is the annual
percentage change of real GDP.
▪ The economic growth rate tells us how rapidly the total
economy is expanding.
 4.2. The basics of economic growth

▪ To calculate this growth rate, we use the

formula:
Real GDP in Real GDP in
Growth of –
current year previous year x 100
real GDP =
Real GDP in previous year

For example, if real GDP in the current year is $8.4

trillion and if real GDP in the previous year was $8.0
trillion, then the growth rate of real GDP is :

Growth of $8.4 trillion – $8.0 trillion

real GDP = x 100 = 5 percent.
$8.0 trillion
 4.2. The basics of economic growth
To calculate this growth rate, we use the formula:

𝒕 𝒕−𝟏
𝒀 − 𝒀
𝒈𝒕 (%) = 𝒕−𝟏
× 𝟏𝟎𝟎
𝒀

where gt is the economic growth rate of period t;

Y is real GDP of period t

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4.2. The Basics of Economic Growth

▪ The standard of living depends on real GDP per

person.
▪ Real GDP per person is real GDP divided by the
population.
▪ Real GDP per person grows only if real GDP
grows faster than the population grows.
 4.2. The basics of economic growth
▪ We use the above formula to calculate this growth
rate, replacing real GDP with real GDP per person.
▪ Suppose, for example, that in the current year,
when real GDP is $8.4 trillion, the population is 202
million.
▪ Then real GDP per person is $8.4 trillion divided by
202 million, which equals $41,584.
▪ And suppose that in the previous year, when real
GDP was $8.0 trillion, the population was 200
million.
▪ Then real GDP per person in that year was $8.0
trillion divided by 200 million, which equals $40,000.
 4.2. The basics of economic growth

▪ The growth rate of real GDP per person can

also be calculated by using the formula:

Growth of real
= Growth rate of – Growth rate of
GDP per person real GDP population

Growth of 202 million – 200 million

= x 100 = 1 percent.
population 200 million
4.2. The basics of economic growth

Growth of real
GDP per person = 5 percent – 1 percent = 4 percent.

▪ This formula makes it clear that real GDP per

person grows only if real GDP grows faster
than the population grows.
▪ If the growth rate of the population exceeds
the growth of real GDP, real GDP per person
falls.
 4.2. The basics of economic growth
▪
 4.2. The basics of economic growth
▪
 4.2. The basics of economic growth
▪
 4.2. The basics of economic growth
▪ The Magic of Sustained Growth
▪ Rule of 70
▪ The number of years it takes for the level of any
variable to double is approximately 70 divided
by the annual percentage growth rate of the
variable.
 4.2. The Basics of Economic Growth
▪ Applying the Rule of 70
▪ Figure 6.1 show the
doubling time for
growth rates.
▪ A variable that grows
at 7 percent a year
doubles in 10 years.
▪ A variable that grows
at 2 percent a year
doubles in 35 years.
▪ A variable that grows
at 1 percent a year
doubles in 70 years.
 Active learning
1. Brazil’s real GDP was 1,360 trillion reais in 2009
and 1,434 trillion reais in 2010. Brazil’s population
was 191.5 million in 2009 and 193.3 million in
2010. Calculate
a. The economic growth rate.
b. The growth rate of real GDP per person.
c. The approximate number of years it takes for
real GDP per person in Brazil to double if the
2010 economic growth rate and population
growth rate are maintained
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 Active learning
2.Japan’s real GDP was 525 trillion yen in 2009
and 535 trillion yen in 2010. Japan’s population
was 127.6 million in 2009 and 127.5 million in
2010. Calculate
a. The economic growth rate.
b. The growth rate of real GDP per person.
c. The approximate number of years it takes for
real GDP per person in Japan to double if the
real GDP economic growth rate returns to 3
percent a year and the population growth rate
is maintained
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4.3. Sources of Economic Growth
▪ To understand what determines the growth rate
of real GDP, we must understand what
determines the growth rates of the factors of
production and rate of increase in their
productivity.
▪ All the influences on real GDP growth can be
divided into those that increase:
▪ Labor productivity
 4.3. Sources of Economic Growth
4.3.1. Productivity
A country’s standard of living depends on its ability
to produce goods and services
▪ Productivity
▪ Quantity of goods and services
▪ Produced from each unit of labor input
▪ Productivity = Y/L (output per worker), where
▪ Y = real GDP = quantity of output produced
▪ L = quantity of labor

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 4.3. Sources of Economic Growth
4.3.1. Productivity
▪ Why productivity is so important
▪ Key determinant of living standards
▪ When a nation’s workers are very productive, real
GDP is large and incomes are high
▪ Growth in productivity is the key determinant of
growth in living standards
▪ When productivity grows rapidly, so do living
standards
▪ An economy’s income is the economy’s output

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 4.3. Sources of Economic Growth
4.3.2. Determinants of Productivity
▪ Physical capital, K
▪ Stock of equipment and structures used to
produce goods and services
▪ Physical capital per worker, K/L
▪ Productivity is higher when the average worker
has more capital (machines, equipment, etc.).
▪ An increase in K/L causes an increase in Y/L

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 4.3. Sources of Economic Growth
4.3.2. Determinants of Productivity
▪ Human capital, H
▪ Knowledge and skills workers acquire through
education, training, and experience
▪ Human capital per worker, H/L
▪ Productivity is higher when the average worker
has more human capital (education, skills, etc.).
▪ An increase in H/L causes an increase in Y/L.

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 4.3. Sources of Economic Growth
4.3.2. Determinants of Productivity
▪ Natural resources, N
▪ Inputs into production that nature provides (land,
rivers, and mineral deposits)
▪ Natural resources per worker, N/L
▪ Other things equal, more N allows a country to
produce more Y
▪ An increase in N/L causes an increase in Y/L

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 4.3. Sources of Economic Growth
4.3.2. Determinants of Productivity
▪ Technological knowledge
▪ Society’s understanding of the best ways to
produce goods and services
▪ Technological progress means:
▪ A faster computer, a higher-definition TV, or a
smaller cell phone
▪ Also, any advance in knowledge that boosts
productivity: allows society to get more output
from its resources
▪ e.g., Henry Ford and the assembly line.
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 4.3. Sources of Economic Growth
4.3.2. Determinants of Productivity
Technological knowledge vs. Human capital
▪ Technological knowledge
▪ Refers to society’s understanding of how to
produce goods and services
▪ Human capital
▪ Results from the effort people expend to acquire
this knowledge
▪ Both are important for productivity

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 4.3. Sources of Economic Growth
4.3.3. The Production Function
▪ The production function Y = A F(L, K, H, N)
▪ A graph or equation showing the relation between
output and inputs
▪ F( ) is a function that shows how inputs are
combined to produce output
▪ “A” is the level of technology
▪ “A” multiplies the function F( ), so improvements in
technology (increases in “A”) allow more output
(Y) to be produced from any given combination of
inputs.

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 4.3. Sources of Economic Growth
4.3.3. The Production Function
Y = A F(L, K, H, N)
▪ The production function has the property
constant returns to scale:
▪ Changing all inputs by the same percentage
causes output to change by that percentage.
▪ Doubling all inputs (multiplying each by 2)
causes output to double:
2Y = A F(2L, 2K, 2H, 2N)
▪ Increasing all inputs 10% (multiplying each
by 1.1) causes output to increase by 10%:
1.1Y = A F(1.1L, 1.1K, 1.1H, 1.1N)
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 4.3. Sources of Economic Growth
4.3.3. The Production Function
Y = A F(L, K, H, N)
▪ If we multiply each input by 1/L, then
output is multiplied by 1/L:
Y/L = A F(1, K/L, H/L, N/L)
▪ This equation shows that productivity (Y/L, output
per worker) depends on:
▪ The level of technology, A
▪ Physical capital per worker, K/L
▪ Human capital per worker, H/L
▪ Natural resources per worker, N,L
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Active Learning Discussion question
Which of the following policies do you think would
be most effective at boosting growth and living
standards in a poor country over the long run?
a. Offer tax incentives for investment by local firms
b. Offer tax incentives for investment by foreign firms
c. Give cash payments for good school attendance
d. Crack down on government corruption
e. Restrict imports to protect domestic industries
f. Allow free trade
g. Give away condoms
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 4.4. Economic Growth and Public Policy
▪ The ways public policy can affect
long-run growth in productivity and living
standards:
▪ Saving and investment
▪ Diminishing returns and the catch-up effect
▪ Investment from abroad; Education
▪ Health and nutrition
▪ Property rights and political stability
▪ Free trade; Research and development
▪ Population growth

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 4.4. Economic Growth and Public Policy
4.4.1.Saving and Investment
▪ Raise future productivity
▪ Invest more current resources in the production of
capital, K
▪ Trade-off: since resources scarce, producing more
capital requires producing fewer consumption goods
▪ Reducing consumption = increasing saving
▪ This extra saving funds the production of investment
goods (More details in the next chapter.)

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 Diminishing Returns
▪ Policies that raise saving and investment
▪ Fewer resources are used to make
consumption goods
▪ More resources: to make capital goods
▪ K increases, rising productivity and living
standards
▪ This faster growth is temporary, due to
diminishing returns to capital: As K rises, the
extra output from an additional unit of K falls….

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The Production Function & Diminishing Returns
Output per worker
(productivity)
Y/L
If workers
have little K,
giving them more
increases their
productivity a lot.

If workers already
have a lot of K,
giving them more
increases
K/L
productivity
fairly little. Capital per worker

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The catch-up effect: the property whereby poor
countries tend to grow more rapidly than rich
ones
Y/L

Rich country’s
growth

Poor country’s
growth

K/L
Poor country
starts here Rich country starts here
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 Example of the Catch-Up Effect
▪ 1960–1990
▪ The U.S. and S. Korea devoted a similar share
of GDP to investment
▪ Expect: similar growth performance
▪ But growth was >6% in Korea and only 2% in
the U.S.
▪ Explanation: the catch-up effect
▪ In 1960, K/L was far smaller in Korea than
in the U.S., hence Korea grew faster

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 4.4.2. Investment from Abroad
▪ Investment from abroad
▪ Another way for a country to invest in new
capital
▪ Foreign direct investment
▪ Capital investment that is owned and operated by
a foreign entity
▪ Foreign portfolio investment
▪ Investment financed with foreign money but
operated by domestic residents

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 4.4.2. Investment from Abroad
▪ Benefits from investment from abroad
▪ Some benefits flow back to the foreign
capital owners
▪ Increase the economy’s stock of capital
▪ Higher productivity and higher wages
▪ State-of-the-art technologies developed in
other countries
▪ Especially good for poor countries that
cannot generate enough saving to fund
investment projects themselves
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 4.4.3. Education
▪ Education, investment in human capital
▪ Gap between wages of educated and
uneducated workers
▪ In the U.S., each year of schooling raises a
worker’s wage by 10%
▪ Opportunity cost: wages forgone
▪ Spending a year in school requires sacrificing
a year’s wages now to have higher wages later
▪ Problem for poor countries: Brain drain

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 4.4.4. Health and Nutrition
▪ Health care expenditure
▪ Is a type of investment in human capital:
healthier workers are more productive
▪ In countries with significant malnourishment,
raising workers’ caloric intake raises productivity:
▪ 1962–1995, caloric consumption rose 44% in
S. Korea, and economic growth was
spectacular.
▪ Nobel winner Robert Fogel: 30% of Great
Britain’s growth from 1790–1980 was due to
improved nutrition
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 4.4.4. Health and Nutrition
▪ Vicious circle in poor countries
▪ Poor countries are poor because their
populations are not healthy
▪ Populations are not healthy because they are
poor and cannot afford better healthcare and
nutrition
▪ Virtuous circle
▪ Policies that lead to more rapid economic
growth would naturally improve health
outcomes, which in turn would further promote
economic growth
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4.4.5. Property Rights and Political Stability
Markets are usually a good way to organize
economic activity
▪ To foster economic growth
▪ Protect property rights (the ability of people to
exercise authority over the resources they
own)
▪ Courts – enforce property rights
▪ Promote political stability
▪ Property rights:
▪ Prerequisite for the price system to work
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4.4.5. Property Rights and Political Stability

▪ Lack of property rights, a major problem

▪ Contracts are hard to enforce
▪ Fraud, corruption often goes unpunished
▪ Firms must bribe government officials for permits
▪ Political instability (e.g., frequent coups)
▪ Creates uncertainty over whether property rights
will be protected in the future

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4.4.5. Property Rights and Political Stability
▪ When people fear their capital may be
stolen by criminals/confiscated by a corrupt
government
▪ Less investment, including from abroad, and
the economy functions less efficiently
▪ Result: lower living standards
▪ Economic stability, efficiency, and healthy
growth
▪ Require law enforcement, effective courts, a
stable constitution, honest government officials
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 4.4.6. Free Trade
Trade can make everyone better off
▪ Inward-oriented policies
▪ i.e. tariffs, limits on investment from abroad
▪ Aim to raise living standards by avoiding
interaction with other countries
▪ Outward-oriented policies
▪ i.e. elimination of restrictions on trade or
foreign investment
▪ Promote integration with the world
economy
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 4.4.6. Free Trade
▪ Trade has similar effects as discovering
new technologies
▪ Improves productivity and living standards
▪ Countries with inward-oriented policies
▪ Have generally failed to create growth.
▪ e.g., Argentina during the 20th century.
▪ Countries with outward-oriented policies
▪ Have often succeeded
▪ e.g., South Korea, Singapore, Taiwan after 1960

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 4.4.7. Research and Development
▪ Technological progress
▪ Main reason why living standards rise over the
long run
▪ Knowledge is a public good
▪ Ideas can be shared freely, increasing the
productivity of many
▪ Policies to promote technological progress:
▪ Patent laws; Tax incentives or direct support
for
private sector R&D
▪ Grants for basic research
52 at universities
 4.4.8. Population Growth
▪ Large population
▪ More workers to produce goods and services:
larger total output of goods and services
▪ More consumers
▪ Population growth may affect living standards in
3 different ways…

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 4.4.8. Population Growth
1. Stretching natural resources
▪ 200 years ago, Malthus argued that population
growth will:
▪ Strain society’s ability to provide for itself
▪ Mankind - doomed to forever live in poverty
▪ Since then, the world population has increased
sixfold and living standards increased
▪ Malthus failed to account for technological
progress and productivity growth

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 4.4.8. Population Growth
2. Diluting the capital stock
▪ High population growth (higher L)
▪ Spread the capital stock more thinly (lower K/L)
▪ Lower productivity and living standards
▪ To combat this, many developing countries
use policy to control population growth
▪ Government regulation (China’s one child law)
▪ Increased awareness of birth control
▪ Equal opportunities for women (Promote female
literacy to raise opportunity cost of having babies)
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 4.4.8. Population Growth
3. Promoting technological progress
▪ World population growth
▪ Engine for technological progress and economic
prosperity
▪ More people = More scientists, more inventors, more
engineers = More frequent discoveries
▪ Michael Kremer, human history:
▪ Growth rates increased as the world’s population
increased
▪ More populated regions grew faster than less
populated ones
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Active Learning Review productivity concepts

▪ List the determinants of productivity.

▪ List three policies that attempt to raise living
standards by increasing one of the determinants of
productivity.

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 Are Natural Resources a Limit to
Growth?
▪ Some argue that population growth
▪ Is depleting the Earth’s non-renewable
resources
▪ And thus will limit growth in living standards.
▪ But technological progress often yields ways to
avoid these limits:
▪ Hybrid cars use less gas.
▪ Better insulation in homes reduces the energy
required to heat or cool them.

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 Are Natural Resources a Limit to
Growth?
▪ Market economy, scarcity is reflected in market
prices
▪ If the world were running out of natural
resources, their prices would be rising over time
▪ In real terms, the prices of most natural
resources are stable or falling
▪ It appears that our ability to conserve these
resources is growing more rapidly than their
supplies are dwindling

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 Conclusion
▪ In the long run
▪ Living standards are determined by productivity
▪ Policies that affect the determinants of
productivity
▪ Will therefore affect the next generation’s living
standards
▪ One of these determinants: saving &
investment
▪ Next chapter: how saving and investment are
determined, and how policies can affect them
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