CHAPTER-6 (PARKIN, M):

ECONOMIC GROWTH

COURSE TEACHER:
D R . TA M G I D A H M E D C H O W D H U R Y
A S S O C I AT E P R O F E S S O R , S B E
OBJECTIVES OF THE CHAPTER

• After completing this chapter, students will be able to understand:

 How and why economic growth takes place
 How a country’s standard of living depends on its saving and population
growth rates
 Different growth theories including classical, neo classical and new growth
theories
 Impacts of population growth over economic growth
WHAT IS ECONOMIC GROWTH? WHY GROWTH MATTERS

 The annual percentage change in an economy’s production of (or capacity to produce)

output
 Measured by the percentage change in real GDP every year
 Real GDP per person is real GDP divided by the population.
 In Pakistan, 85% of people live on less than $2/day.
 One-fourth of the poorest countries have had famines during the past 3 decades.
 Persistent poverty is associated with oppression of women and minorities.
Economic growth raises living standards and reduces poverty….
 INCOME AND POVERTY IN THE WORLD
SELECTED COUNTRIES, 2000
100
Madagascar
90
India

living on $2 per day or less

80 Nepal
% of population 70 Bangladesh

60 Kenya Botswana
50 China
40 Peru
Mexico
30 Thailand
20
Brazil Chile
10 Russian
S. Korea
Federation
0
$0 $5,000 $10,000 $15,000 $20,000
Income per capita in dollars
THE BASICS OF ECONOMIC GROWTH
• Economic Growth Versus Business Cycle Expansion

–Real GDP can increase for two distinct reasons:

1. The economy might be returning to full employment in an expansion phase of the

business cycle.

2. Potential GDP might be increasing.

–The return to full employment in an expansion phase of the business cycle isn’t
economic growth.

–The expansion of potential GDP is economic growth.

THE BASICS OF ECONOMIC GROWTH
–This Figure illustrates the
distinction.
–A return to full employment in a
business cycle expansion is a
movement from inside the PPF
(point A) to a point on the PPF
(point B).
–Economic growth is the outward
shift of the PPF from PPF0 to
PPF1 and the movement from
point B on PPF0 to point C on
PPF1.
 GROWTH RATES MATTER
•The Magic of Sustained Growth

•The Rule of 70 states that the number of

years it takes for the level of a variable to
double is approximately 70 divided by the
annual percentage growth rate of the variable.
•Applying the Rule of 70
–This Figure shows 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.
ECONOMIC GROWTH TRENDS
–This Figure shows the
growth of real GDP per
person in a group of poor
countries.
–The gaps between real GDP
per person in the United
States and in these countries
have widened.
THE CAUSES OF ECONOMIC GROWTH:
A FIRST LOOK
• Preconditions for Economic Growth
– The basic precondition or prerequisite for economic growth is an appropriate incentive system.
– Three institutions that help with the creation of appropriate incentives are:
 Markets
 Clear and certain property rights
 Monetary exchange
– For economic growth to persist, society somehow needs to ensure these three activities:
 Saving and investment in new capital
 Investment in human capital
 Discovery of new technologies
THE CAUSES OF ECONOMIC GROWTH:
A FIRST LOOK
• Saving and Investment in New Capital
– The accumulation of capital dramatically increases output and productivity; one US
farmer can feed many, many households.
• Investment in Human Capital
– Human capital acquired through education, on-the-job training, and learning-by-doing can
also dramatically increase output and productivity.
• Discovery of New Technologies
– Technological advances contribute immensely to increasing productivity; think what you
can do with a PC, things that were impossible for your parents without months of work.
GROWTH ACCOUNTING
– The quantity of real GDP supplied, Y, depends on the quantity of labor, L, the quantity of
capital, K, and the state of technology, T.
– The purpose of growth accounting is to estimate how much real GDP growth comes
from growth of labor and capital inputs, and how much is apparently because of
technological change
– Growth accounting is based on the aggregate production function,
– Y = F(L, K, T ).
• Labor Productivity
– Labor productivity is real GDP per hour of labor or per unit of labor; it equals real GDP
divided by aggregate hours or real GDP divided by total number of labor.
THE GROWTH ACCOUNTING
 In aggregate terms: Y = F (K, L)
 Define: y = Y/L = output per worker
k = K/L = capital per worker
 Assume constant returns to scale:
zY = F (zK, zL ) for any z > 0

 Pick z = 1/L. Then

Y/L = F (K/L, 1)
y = F (k, 1)
y = f(k) where f(k) = F(k, 1)
 THE PRODUCTION FUNCTION
Output per
worker, y
f(k)

MPK = f(k +1) – f(k)

1

Note:
Note: this
thisproduction
productionfunction
function
exhibits
exhibitsdiminishing
diminishingMPK.
MPK.

Capital per
worker, k
GROWTH ACCOUNTING
– The shape of the productivity curve reflects the law of diminishing returns.
– The law of diminishing returns states that, as the quantity of one input
increases with the quantities of all other inputs remaining the same, output
increases but eventually by ever smaller increments.
– Robert Solow discovered that diminishing returns are well described by the
one-third rule: with no change in technology, on the average, a 1 percent
increase in capital per hour of work brings a one-third of 1 percent increase
in output per hour of labor.
GROWTH THEORIES
• Classical Growth Theory
– Classical growth theory came to the conclusion that real GDP growth was temporary;
when real GDP per person rises above the subsistence level, a population explosion brings
real GDP per person back to the subsistence level.
– The basic classical idea
– There is a subsistence real wage rate, which is the minimum real wage rate needed to
maintain life and match births to deaths.
– Advances in technology shifts the productivity curve up.
– Labor productivity increases and the real wage rate rises above the subsistence level.
– When the real wage rate is above the subsistence level, the population grows – births
exceed deaths.
GROWTH THEORIES
– This Figure
illustrates the
classical
growth
theory.
GROWTH THEORIES
• Neoclassical Growth Theory
– Neoclassical growth theory posits that real GDP per person grows because
technological change induces a level of saving and investment that makes
capital per hour of labor grow.
– Growth ends only if technological change stops.
– The neoclassical view is that the population growth rate is independent of
both real GDP per person and its growth rate.
– The population growth rate equals the birth rate minus the death rate.
– The birth rate is influenced by the opportunity cost of a woman’s time.
GROWTH THEORIES
– The basic neoclassical idea
• Target Rate of Return and Saving
• Ceteris paribus, the higher the real interest rate, the greater is the amount that people save. To
decide how much to save, people compare the real interest rate with a target rate of return.
– Technology begins to advance more rapidly.
– New profit opportunities arise.
– Investment and saving increase.
– As technology advances and the capital stock grows, real GDP per person rises.
– Diminishing returns to capital per hour of labor lower the real interest rate and eventually
growth stops unless technology keeps on advancing.
GROWTH THEORIES

– This
Figure
illustrates
neo-
classical
growth
theory.
GROWTH THEORIES
• New Growth Theory
– “New growth theory” holds that real GDP per person grows because of
choices that people make in the pursuit of profit and concludes that growth
can persist indefinitely.
– The theory emphasizes that
 People are always in pursuit of profit
 Discoveries bring profit
 In a market economy, profit brings competition and competition destroys
profit
 People look for more profit, more discoveries take place, more knowledge
is gathered, more growth takes place
 Knowledge is not subject to diminishing returns
DEPRECIATION
Depreciation  == the
the rate
rate of
of depreciation
depreciation
per worker, k == the
the fraction
fraction of
of the
the capital
capital stock
stock
that
that wears
wears out
out each
each period
period

k


1

Capital per
worker, k
CAPITAL ACCUMULATION
The basic idea: Investment increases the capital stock,
depreciation reduces it.

Change in capital stock = investment – depreciation

dk = i – k

Since i = sf(k) , this becomes:

dk = s f(k) – k
 THE STEADY STATE
dk = s f(k) – k
If investment is just enough to cover depreciation
[sf(k) = k ],
then capital per worker will remain constant:
dk = 0.

This occurs at one value of k, denoted k*,

called the steady state capital stock.
MOVING TOWARD THE STEADY STATE
dk = sf(k)  k
Investment
and k
depreciation
sf(k)

k
investment

depreciation

k1 k* Capital per
worker, k
MOVING TOWARD THE STEADY STATE
dk = sf(k)  k
Investment
and k
depreciation
sf(k)

k

k1 k2 k* Capital per
worker, k
 MOVING TOWARD THE STEADY STATE
dk = sf(k)  k
Investment
and k
depreciation
sf(k)

k
investment
depreciation

k2 k* Capital per
worker, k
MOVING TOWARD THE STEADY STATE
dk = sf(k)  k
Investment
and k
depreciation
sf(k)

k

k2 k3 k* Capital per
worker, k
MOVING TOWARD THE STEADY STATE
dk = sf(k)  k
Investment
and k
depreciation
sf(k)
Summary:
Summary:
As
As long
long asas kk << kk**,,
investment
investment willwill exceed
exceed
depreciation,
depreciation,
and
and kk will
will continue
continue to to
grow
grow toward
toward kk**..

k3 k* Capital per
worker, k
AN INCREASE IN THE SAVING RATE
An increase in the saving rate raises investment…
…causing k to grow toward a new steady state:
Investment
and k
depreciation s2 f(k)
s1 f(k)

k 2* k
k 1*
THE IMPACT OF POPULATION GROWTH
Investment,
break-even ( +n 2 ) k
investment
( +n1) k
An
An increase
increase in
in nn
causes sf(k)
causes anan
increase
increase in
in break-
break-
even
even investment,
investment,
leading to a lower
steady-state level
of k.

k2 * k1* Capital per

worker, k
 GROWTH THEORIES
– This Figure summarizes the ideas of new growth theory as a perpetual motion machine.