Chapter 3 Economic growth

Mentor Pham Xuan Truong

[email protected]
Content
1 Definition, computing method and implications of
economic growth
2 Factors decide economic growth in the long run
3 Theories of economic growth
4 Policies to promote economic growth
1 Definition, computing method and
implications of economic growth
Definition
Economic growth is the increase in the market value of the
goods and services produced by an economy over time. It is
conventionally measured as the percent rate of increase
in real gross domestic product, or real GDP
To reflect more accurately about living standard of each
person in country, economists use the growth of the ratio of
GDP to population (GDP per capita), which is also
called income per capita
An increase in per capita income is referred to as intensive
growth. GDP growth caused only by increases in population
or territory is called extensive growth
 1 Definition, computing method and
implications of economic growth
Computing method
+ Absolute growth (in number)

+ Relative growth (in percentage)

Yt  Yt 1
Using total real GDP gt   100%
Yt 1
y t  y t 1
Using real GDP per capita g pct   100%
y t 1
1 Definition, computing method and
implications of economic growth
+ Average growth

y n  y 0 (1  g a ) n

yn
ga  n 1
y0
yn GDP at the end of period
y0 GDP in the beginning of
period
ga average growth in period
n number of year (month) in
Rule of thumb: rule of 70
A way to estimate the number of years it takes for a
certain variable to double. The rule of 70 states that in
order to estimate the number of years for a variable to
double, take the number 70 and divide it by the growth
rate of the variable (70/g). This rule is commonly used
with an annual compound interest rate to quickly
determine how long it would take to double your money.
If the growth rate is greater than 4% we use 72 for
dividing (rule of 72)
Similarly, we have rule of 110 for triple growth and rule
of 140 for quadruple growth
1 Definition, computing method and
implications of economic growth
Implications
- Enhance people’s income, thereby improving living
standard
- Create jobs, mitigate unemployment (Okun’s law)
- Provide finance to strengthen national security,
political credibility
- With low income countries, high economic growth rate
helps these countries to catch up high income ones
 The variety of growth experiences
Country Period Real GDP per person Real GDP per person Growth rate
at beginning of period at end of period (per year)
Japan 1890–2006 $1,408 $33,150 2.76%
Brazil 1900–2006 729 8,880 2.39
China 1900–2006 670 7,740 2.34
Mexico 1900–2006 1,085 11,410 2.24
Germany 1870–2006 2,045 31,830 2.04
Canada 1870–2006 2,224 34,610 2.04
Argentina 1900–2006 2,147 15,390 1.88
United States 1870–2006 3,752 44,260 1.83
India 1900–2006 632 3,800 1.71
United Kingdom 1870–2006 4,502 35,580 1.53
Indonesia 1900–2006 834 3,950 1.48
Bangladesh 1900–2006 583 2,340 1.32
Pakistan 1900–2006 690 2,500 1.22
2 Factors decides economic growth in the
long run
Economic growth in long run means the increase of
productivity (quantity of goods and services produced
from each unit of labor input).
Productivity is so important because it is the key
determinant of living standards (an economy’s income is
the economy’s output)
The question is how productivity is determined
 2 Factors decides economic growth in the
long run
How productivity is determined
Physical capital (K)
Stock of equipment and structures
Used to produce goods and services
Human capital (H)
Knowledge and skills that workers acquire through
education, training, and experience
Natural resources (R)
Inputs into the production of goods and services
Provided by nature, such as land, rivers, and mineral deposits
Technological knowledge (T)
Society’s understanding of the best ways to produce goods
and services
3 Theories of economic growth
Classical theory

Land plays an important role for economic

growth
Production expansion depends on savings of capitalist
Savings of capitalist depends on profit
Profit depends on production cost
Production cost depends on labor cost
Labor cost depends on food price
Food price depends on land area
 3 Theories of economic growth
Keynesian theory – Harrod Domar model

Capital accumulation plays an important role for economic

growth
According to Harrod – Domar model

g - economic growth, s - national saving rate, k - ICOR

(incremental capital output ratio) index

K
ICOR 
Y
3 Theories of economic growth
Keynesian theory – Harrod Domar model
Conclusions drawn by Harrod - Domar model:
- Economic growth rate (g) has positive relationship
with saving rate (s) and negative relationship with
ICOR index (k)
- Due to constant k in short run, s is the most
determinant of g
- There is a trade off between current consumption and
future consumption
3 Theories of economic growth
Neoclassical theory – Solow model
We build Solow model from constant return production
function Y = f (K,L)
We transform the function:
1 1 1
y  Y .  f ( K . , L. )  f ( k )
L L L
y – products per capita or income per capita
k – capital per capita
3 Theories of economic growth
Neoclassical theory – Solow model
Graph illustrating the relationship between k and y
3 Theories of economic growth
Neoclassical theory – Solow model
Two key questions from the graph
- Why pace of output increase becomes slow (slop of
production curve)?
- How economy overcomes steady state?
Answer two questions
- Slow pace of output increase due to diminishing
marginal return of capital
- To overcome steady state, it requires technological
advances
3 Theories of economic growth
Neoclassical theory – Solow model

However technological advance in Solow model is given

variable (exogenous variable). Therefore, Solow model
is also called exogenous growth model.
 3 Theories of economic growth
Neoclassical theory – Solow model
Catch – up effect (convergence)
3 Theories of economic growth
Neoclassical theory – Solow model
Conclusions drawn by Solow model:
- The role of savings for economic growth
- Capital accumulation is good for short run economic
growth
- Technology is the determinant of long run economic
growth
3 Theories of economic growth
Modern theory – endogenous model
Later economist (Paul Romer, Grossman, Mankiw…)
proposed economic growth model in which
technological advances are determined by R&D
investment, government spending for education, number
of workers in knowledge producing area…
Because now technological advances are internally
decided then modern theory is also called as endogenous
growth model
 4 Policy to promote economic growth
Saving and investment: Raise future productivity
Invest more current resources in the production of
capital
Trade-off: Devote fewer resources to produce goods
and services for current consumption
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
 4 Policy to promote economic growth
Education: Investment in human capital
Gap between wages of educated and uneducated workers
Opportunity cost: wages forgone
Conveys positive externality
Brain drain (problem for poor countries)
Health and nutrition: Healthier workers – more productive
The right investments in the health of the population: One
way for a nation to increase productivity and raise living
standards
Historical trends of long-run economic growth: Improved
health - from better nutrition and Taller workers – higher
wages – better productivity
4 Policy to promote economic growth
Property rights and political stability: Create favorable
institutions
Protect property rights: Ability of people to exercise
authority over the resources they own
Promote political stability
Free trade: Utilize national advantages
Inward-oriented policies: avoid interaction with the
rest of the world
Outward-oriented policies: integrate into the world
economy
 4 Policy to promote economic growth
Research and development : Knowledge – public good that enhances
technology
Research Institutes or other science programs funded by government
Research grants
Tax breaks
Patent system

Population growth: Large population create both advantages and

disadvantages
Stretching natural resources
Diluting the capital stock
Reduces GDP per worker
But
Promoting technological progress
Large labor force
More consumers
Key concepts
- Economic growth
- Income per capita
- Living standard
- Rule of 70
- Human capital, Physical capital, Natural resources,
Technology advance
- Classical theory
- Keynesian theory, Harrod – Domar model
- Neo-classical theory, Solow model
- Steady state
- Endogenous model
- R&D