ECON 1220 Principles of Macroeconomics

Semester 2, 2011/12

The Long-Run Economic Growth

1. Economic Growth Economists usually define economic growth as an increase in real GDP or real GDP per capita: o Real GDP per capita = Real GDP/Population. o A measure of living standard.

The real GDP per capita growth rates o U.S.: around 2.3% annually since 1950s o China: around 8% annually sine 1980s. The small difference in the growth rates makes a big difference in long term: o The rule of 70 (mathematical approximation) shows that the approximate number of years required to double real GDP per capita (or any variable) is 70 divided by the annual growth rate (percentage change in the variable). o Given the stable annual growth rate of 2.3%, U.S. will double its real GDP per capita in 70/2.3 = 30.43 years.

ECON 1220 Principles of Macroeconomics

Semester 2, 2011/12

If China maintains its annual growth rate of 8%, it will double its real GDP per capita in 70/8 = 8.75 years.

What are the sources of economic growth? Why some economies grow faster than others?

2. The Determinants of Economic Growth What are the determinants of real GDP per capita1?
T otalemployment Real GDP Real GDP Population T otalemployment Population Real GDP Labor Productivi Employment Population ty to Ratio (EPR) Population

Recall that in the classical model, the long-run output level (potential GDP) is determined by the supply side. The amount of output an economy produces depends on two factors: o The amounts of inputs (such as labor and capital) utilized in the production. o The production technology to transform inputs into outputs. Therefore, the major factors affecting labor productivity are: o The amounts of other inputs, mainly capital. o The production technology. On the other hand, the EPR is determined by the labor market equilibrium.

3. Growth in Employment to Population Ratio (EPR) With a given population, greater total employment means an increase in the EPR, and a rise in real GDP per capita. In the long run classical model, the total employment is determined by the labor market equilibrium. o What are the factors affecting labor demand and supply? What government policies might affect labor demand and supply? o Examples of policies that affect labor supply Marginal income tax rate (supply-side economists) Retirement age Unemployment benefits reform o Examples of policies that affect labor demand Anything that helps to increase the labor productivity, such as subsidies for education and training Other policies that may affect the marginal benefits of employing labor such as corporate tax or share of payroll tax contributed by employers

Here we measure labor by labor-hours, so it is equivalent to the equation in your textbook. Besides it is tedious to distinguish average hours as it is relatively stable in most industrialized countries.

ECON 1220 Principles of Macroeconomics

Semester 2, 2011/12

Real wage (W/P) LS1

LS2

(W/P)

LD2 LD1

Labor (L) Output (Y)

Production Function YF2 YF1

LF1

LF2

Labor (L)

Is raising EPR a way to generate sustained economic growth? o The maximum value of EPR is 1. o EPR may rise and so create economic growth temporarily (while the ERR is rising). But sustained economic growth would require significant, sustained growth in the EPR, which is not realistic.

4. Growth in Productivity: The Increase in Capital Stock The most important determinant of long-run economic growth is raising labor productivity. In the classical model, the major factors affecting labor productivity (supply shocks) are: o The amounts of other inputs, mainly capital.

ECON 1220 Principles of Macroeconomics

Semester 2, 2011/12

The production technology

Real wage (W/P) LS

(W/P)

LD2 LD1

Labor (L) Output (Y)

YF2

Y = f(K2, L)

YF1

Y = f(K1, L)

LF1

LF2

Labor (L)

To understand the determinants of the growth in capital level and its growth, we have to examine how an economys capital stock accumulates: The change in capital stock = planned investment depreciation of existing capital.

Therefore, for a given rate of capital depreciation and given total employment, the major determinant of the growth in capital stock is planned investment. o In the classical model, the amount of planned investment (hence new capital stock) is determined by the loanable market equilibrium. o What are the factors affecting the demand and supply of loanable funds?

ECON 1220 Principles of Macroeconomics

Semester 2, 2011/12

What government policies might affect loanable funds demand and supply? o Examples of policies that affect the supply of loanable funds (household saving) Consumption taxes Capital gain taxes o Examples of policies that affect the demand for loanable funds Budget deficit (crowding out effect) What kind of government spending to cut? Public investment in infrastructure Other policies that may affect the marginal benefits of investment such as corporate profits tax or investment tax credit

So far we have focused on a single other input, physical capital only, but the economys other inputs may include human capital. o Human capital refers to the skills and knowledge possessed by labors. o The amount of human capital labor would invest in involves the marginal benefits and marginal costs comparison as in the cases of other input demand. o To increase the investment in human capital, the government should pursue policies that reduce the cost of investment (i.e. interest rate) and increase the benefits (i.e. profitability of human capital to households). Is increasing capital stock a way to generate sustained economic growth? o Diminishing marginal returns. o Given a fixed depreciation rate, increasing capital stock results in greater amount of capital being depreciated each year. Much of the investment expenditure are used to replace the capital worn out instead adding new capital.

5. Growth in Productivity: Technological Change Economists generally agree that technology progress is the source of sustained economic growth. o Technological progress refers to the invention and use of new inputs, new outputs, or new methods of production, which results in more output, given the same amount of inputs. Economic growth, especially in develoed countries, is mainly based on discovery-based growth (i.e. technological change from new discoveries) In developing countries, sustained growth is largely catch-up growth (i.e. rapid technological change by copying and adapting technologies already in use in rich countries) How might government promote technological progress? o Research & Development spending: Subsidies Direct spending on R&D o Institutional infrastructure that encourages innovation Enforcement of property right protection, such as patent (but there may be a counter effect) o International openness that encourages inflow of technology.

ECON 1220 Principles of Macroeconomics

Semester 2, 2011/12

Empirical studies show that openness to international trade is good for economic growth: Sachs and Warner (1995): o Among developed nations: the open economies grew at 2.3% per year, while the closed economies grew at 0.7% per year. o Among developing nations: the open economies grew at 4.5% per year, while the closed economies grew at 0.7% per year. Some countries trade less simply because they are geographically disadvantaged: New Zealand is farther from other populous countries. Landlocked countries are also disadvantaged compared to countries with their own seaports, such as Hong Kong and Singapore.

Legal institutions: La Porta, Lopez-de-Silanes, Shleifer and Vishny (1998): Legal protections for shareholders and creditors are stronger in English-style legal systems (such as U.S., Australia, India, Singapore, Hong Kong) than French-style legal systems (such as Italy, Spain and most of the Latin American countries). As a result, the English-style countries have better-developed capital markets. They, in turns, experience more rapid growth because it is easier for small and start-up firms to finance investment projects, leading to more efficient allocation of the nations capital.

6. Costs of Economic Growth Budgetary cost Consumption cost of brute force

Consumption Goods (y)

Capital Goods (x)

Sacrifice of other social goal, such as income inequalities, hardship for those workinh in traditional industries.

Readings: Chapter 21

(http://www.economist.com/node/21528979) on the world economy this week. But it is equally easyand unwiseto think that rapid and trouble-free growth in the emerging economies is assured for years to come. It seems almost churlish to question the outlook for emerging markets after the great strides they have made. China and India are twice as rich as they were a decade ago, taking millions out of poverty. Nor is the good news confined to the two Asian giants. Even before the global financial crisis battered the rich world, dozens of emerging markets were growing at a faster rate than America, the worlds leading economy. The crisis has merely widened what was already a large gap. Yet the growth of emerging economies is unlikely to continue at the same rapid pace or without occasional downturns. As economies become richer, they can rely less and less on the brute force of capital spending, coupled with a steady flow of cheap rural migrants, to fuel their expansion. They have a greater need of a skilled workforce and a modern financial system that is attuned to where the best returns might be found. Countries that have leant on exporting cheap goods to the rich world need instead to turn to internal sources of spending. That risks the ills that have felled emerging markets in the past: excessive credit, government spending and inflation. Much depends on how well China manages its economic transition. The Hong Kong bond issue is one of the early steps China has taken to establish the yuan as a global standard. Further strides would be welcome: the financial crisis is proof that America cannot usefully recycle the worlds excess savings. The yuans acceptance among investors would also require the kind of reform China needs to wean its economy from its investment-heavy, export-oriented growth model. The shift will not be easy. The coming decade is therefore likely to prove harder for the emerging markets. China and others are entering the tricky middle-income stage of development in which the big advances from absorbing rich-world technology start to run out. Trouble has a habit of striking places that avoided the previous crisis and became overconfident. A broad sell-off in emerging-market currencies in recent weeks may be an early sign of softer growth ahead. The weight of the world economy is moving, with remarkable speed, towards the populous emerging markets. But the transition is unlikely to be as smooth as many people assume.
from the print edition | Leaders

The world economy

Catching up is so very hard to do

The emerging economies have had a great decade. That was the easy part
Sep 24th 2011 | from the print edition

THIS month Italys government sold a slug of five-year paper at one of its regular bond auctions. There was barely enough demand for the bonds to meet supply, even at a steep interest rate. Contrast that with the sale in August of 20 billion yuan ($3.1 billion) of paper by China in Hong Kongs fledgling offshore market. The yield was miserly yet there were more than four times as many bids as there were bonds for sale. This tale of two bond auctions is a parable for the contrasting fortunes of near-stagnant rich economies and fast-growing emerging markets. Twenty of the 42 economies covered in the back pages of The Economist grew by 3% or more in the year to the latest quarter. Only two of these, Austria and Sweden, are from the traditional group of rich countries. The rest are developing economies, such as Brazil and Turkey, or newly rich ones, such as Taiwan and Hong Kong. The IMFs latest forecast is that emerging economies will grow by more than 6% in 2011 and 2012. But growth in the rich world is likely to be below 2%. The other half lives The rotten economic news over the summer and the deepening eurozone mess mean it is easy to forget that countries that now account for half the worlds output and most of its population are doing rather well. That is the focus of our special report

which once seemed within easy reach, retreats into the future. Growth rates may slow, as they did in the case of western Europe and the Asian tigers, or they may falter, as in Latin America in the 1990s. The worlds reliance on emerging markets as engines of growth lends urgency to the question of just when this middle-income trap is sprung. In a new paper* Barry Eichengreen of the University of California, Berkeley, Donghyun Park of the Asian Development Bank and Kwanho Shin of Korea University examine the economic record since 1957 in an attempt to identify potential warning-signs. The authors focus on countries whose GDP per head on a purchasingpower-parity (PPP) basis grew by more than 3.5% a year for seven years, and then suffered a sharp slowdown in which growth dipped by two percentage points or more. They ignore slowdowns that occur when GDP per head is still below $10,000 on a PPP basis, limiting the sample to countries enjoying sustained catch-up growth. What emerges is an estimate of a critical threshold: on average, growth slowdowns occur when per-head GDP reaches around $16,740 at PPP. The average growth rate then drops from 5.6% a year to 2.1%. This estimate passes the smell test of history (see chart). In the 1970s growth rates in western Europe and Japan cooled off at approximately the $16,740 threshold. Singapores early-1980s slowdown matches the model, as does the experience of South Korea and Taiwan in the late 1990s. As these examples indicate, a deceleration need not precipitate disaster. Growth often continues and may accelerate again; the authors identify a number of cases in which a slowdown proceeds in steps. Japans initial boom lost steam in the early 1970s, but its economy continued to grow faster than other rich nations until its 1990s blow-up. In the right circumstances the good times may be prolonged, allowing an economy to reach a higher income level before the inevitable slowdown. When America passed the threshold it was the world leader and was able to keep growing rapidly so long as its own innovative

Economics focus

BRIC wall

Growth tends to slow when GDP per head reaches a certain threshold. China is getting close
Apr 14th 2011 | from the print edition

THE economic crisis may have been debilitating for the rich world but for emerging markets it has been closer to a triumph. In 2010 China overtook a limping Japan as the worlds second-largest economy. It looks sets to catch America within a decade or two. India and Brazil are growing rapidly. The past few years have reinforced the suspicion of many that the story of the century will be the inexorable rise of emerging economies. If projections of future growth look rosy for emerging markets, however, history counsels caution. The post-war period is rich in examples of blistering catch-up growth. But at some point growth starts to disappoint. Gaining ground on the leaders is far easier than overtaking them. Rapid growth is initially easy because the leader has already trodden a clear path. Developing countries can borrow existing technologies from countries that have already become rich. Advanced economies may be stuck with obsolete infrastructure; laggards can skip right to the shiniest and best. Labour productivity soars as poor economies shift workers from agriculture to a growing manufacturing sector. And rapid income growth among young workers boosts savings and fuels investment. But the more an emerging economy resembles the leaders, the harder it is to sustain the pace. As the stock of borrowable ideas runs low, the developing economy must begin innovating for itself. The supply of cheap agricultural labour dries up and a rising number of workers take jobs in the service sector, where productivity improvements are more difficult to achieve. The moment of convergence with the leaders,

prowess allowed. Britains experience indicates economic liberalisation or a fortunate turn of the business cycle may also prevent the threshold from binding at once. Openness to trade appears to be a potent stimulant: the authors attribute the outperformance of Hong Kong and Singapore to this effect. Lifting consumption to just over 60% of GDP is useful, as is a low and stable rate of inflation. Neither financial openness nor changes of political regime seem to matter much, but a large ratio of workers to dependents reduces the odds of a slowdown. An undervalued exchange rate, on the other hand, appears to contribute to a higher probability of a slowdown. The reason for this is not clear but the authors suggest that undervaluation could lead countries to neglect their innovative capacity, or may contribute to imbalances that choke off a boom. Middle Kingdom, middle income The authors are careful to say that there is no iron law of slowdowns. Even so, their analysis is unlikely to cheer the leadership in Beijing. Chinas torrid growth puts it on course to hit the $16,740 GDP-perhead threshold by 2015, well ahead of the likes of Brazil and India. Given the Chinese economys long list of risk factorsincluding an older population, low levels of consumption and a substantially undervalued currencythe authors suggest that the odds of a slowdown are over 70%. It is hazardous to extend any analysis to a country as unique as China. The authors acknowledge that rapid development could shift inland, where millions of workers have yet to move into manufacturing, while the coastal cities nurture an ability to innovate. The IMF forecasts real GDP growth rates above 9% through to 2016; a slowdown to 7-8% does not sound that scary. But past experience indicates that slowdowns are frequently accompanied by crises. In East Asia in the late 1990s it became clear that investments which made sense at growth rates of 7%, say, did not at expansion rates of 5%. Political systems may prove similarly vulnerable: it has been many years since China has to deal with an annual growth rate below 7%. Structural reforms can help to cushion the effects of a slowdown. It would be wise for China to pursue such reforms during fat years rather than the leaner ones that will, eventually, come.

* When Fast Growing Economies Slow Down: International Evidence and Implications for China. NBER working paper, March 2011
from the print edition | Finance and economics
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undertaking a progress, the late Deng Xiaoping set out on a southern tour of the most reform-minded provinces. An astonishing endorsement of reform, it was a masterstroke from the man who made modern China. The economy has barely looked back since. Compared with the rich worlds recent rocky times, Chinas progress has been relentless. Yet not far beneath the surface, society is churning. Recent village unrest in Wukan in Guangdong, one province that Deng toured all those years ago; ethnic strife this week in Tibetan areas of Sichuan; the gnawing fear of a house-price crash: all are signs of the centrifugal forces making the Communist Partys job so hard. The partys instinct, born out of all those years of success, is to tighten its grip. So dissidents such as Yu Jie, who alleges he was tortured by security agents and has just left China for America, are harassed. Yet that reflex will make the partys job harder. It needs instead to master the art of letting go. Chinas third revolution The argument goes back to Dengs insight that without economic growth, the Communist Party would be history, like its brethren in the Soviet Union and eastern Europe. His reforms replaced a failing political ideology with a new economic legitimacy. The partys cadres set about remaking China with an energy and single-mindedness that have made some Westerners get in touch with their inner authoritarian. The bureaucrats not only reformed Chinas monstrously inefficient state-owned enterprises, but also introduced some meritocracy to appointments. That mix of political control and market reform has yielded huge benefits. Chinas rise over the past two decades has been more impressive than any burst of economic development ever. Annual economic growth has averaged 10% a year and 440m Chinese have lifted themselves out of povertythe biggest reduction of poverty in history. Yet for Chinas rise to continue, the model cannot remain the same. Thats because China, and the world, are changing. China is weathering the global crisis well. But to sustain a high growth rate, the economy needs to shift away from investment and exports towards domestic consumption. That transition depends on a fairer division of the spoils of growth. At present, Chinas banks shovel workers savings into state-owned enterprises, depriving workers of

China

The paradox of prosperity

For Chinas rise to continue, the country needs to move away from the model that has served it so well
Jan 28th 2012 | from the print edition

IN THIS issue we launch a weekly section devoted to China. It is the first time since we began our detailed coverage of the United States in 1942 that we have singled out a country in this way. The principal reason is that China is now an economic superpower and is fast becoming a military force capable of unsettling America. But our interest in China lies also in its politics: it is governed by a system that is out of step with global norms. In ways that were never true of post-war Japan and may never be true of India, China will both fascinate and agitate the rest of the world for a long time to come. Only 20 years ago, China was a long way from being a global superpower. After the protests in Tiananmen Square led to a massacre in 1989, its economic reforms were under threat from conservatives and it faced international isolation. Then in early 1992, like an emperor

spending power and private companies of capital. As a result, just when some of the other ingredients of Chinas boom, such as cheap land and labour, are becoming scarcer, the government is wasting capital on a vast scale. Freeing up the financial system would give consumers more spending power and improve the allocation of capital. Even todays modest slowdown is causing unrest (see article (http://www.economist.com/node/21543477) ). Many people feel that too little of the countrys spectacular growth is trickling down to them. Migrant workers who seek employment in the city are treated as second-class citizens, with poor access to health care and education. Land grabs by local officials are a huge source of anger. Unrestrained industrialisation is poisoning crops and people. Growing corruption is causing fury. And angry people can talk to each other, as they never could before, through the internet. Party officials cite growing unrest as evidence of the dangers of liberalisation. Migration, they argue, may be a source of growth, but it is also a cause of instability. Workers protests disrupt production and threaten prosperity. The stirrings of civil society contain the seeds of chaos. Officials are particularly alive to these dangers in a year in which a new generation of leaders will take power. That bias towards control is understandable, and not merely selfinterested. Patriots can plausibly argue that most people have plenty of space to live as individuals and value stability more than rights and freedoms: the Arab spring, after all, had few echoes in China. Yet there are rights which Chinese people evidently do want. Migrant workers would like to keep their limited rights to education, health and pensions as they move around the country. And freedom to organise can help, not hinder, the countrys economic rise. Labour unions help industrial peace by discouraging wildcat strikes. Pressure groups can keep a check on corruption. Temples, monasteries, churches and mosques can give prosperous Chinese a motive to help provide welfare. Religious and cultural organisations can offer people meaning to life beyond the insatiable hunger for rapid economic growth. Our business now Chinas bloody past has taught the Communist Party to fear chaos above all. But historys other lesson is that those who cling to absolute power end up with none. The paradox, as some within the party are coming to realise, is that for China to succeed it must move away from

the formula that has served it so well. This is a matter of more than intellectual interest to those outside China. Whether the country continues as an authoritarian colossus, stagnates, disintegrates, or, as we would wish, becomes both freer and more prosperous will not just determine Chinas future, but shape the rest of the worlds too.
from the print edition | Leaders
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