The Open Economy Economic Growth

Read Chapter 10 & 11

1.
2.
3.
4.
5.

What is economic growth?

What determines economic growth
How to promote economic growth
Costs/limits to growth?
Developing a model of economic growth

Read: Bernanke Chapter 10 and Chapter 11

Record of transactions between residents of a country and

non-residents

Current Account
Transactions leading to a change of ownership of
commodities or a direct flow of income

Capital Account
Transactions involving the purchase or sale of
assets

Balance on merchandise trade (exports less imports of

goods)
(plus) Net services
(plus) Net income (includes labour and property
income; interest, dividend and royalty payments)
(plus) Current transfers (migrant funds, foreign aid)
(equals) Balance on Current Account
When the balance is negative, it is known as a
current account deficit; when positive, a current
account surplus
4

That part of the balance of payments that records

transactions leading to a change of ownership of
commodities, or a direct flow of income or similar
payment, is known as:
A. net external assets

B. the current account

C. the balance on merchandise trade

D. terms of trade
5

That part of the balance of payments that records

transactions leading to a change of ownership of
commodities, or a direct flow of income or similar
payment, is known as:
A. net external assets

B. the current account

C. the balance on merchandise trade

D. terms of trade
6

That part of the balance of payments that records

transactions leading to either the purchase or sale of
domestic assets is known as:
A. net external assets
B. the current account
C. the balance on merchandise trade
D. the capital account

That part of the balance of payments that records

transactions leading to either the purchase or sale of
domestic assets is known as:
A. net external assets
B. the current account
C. the balance on merchandise trade
D. the capital account

Which of the following is a debit item in the Australian current

account?
A. The sale of wool to Italy
B. An Australian consulting company receives payment from an
overseas firm

C. The fees paid by overseas students at an Australian university

D. An Australian company pays for consulting services from an
overseas firm

Which of the following is a debit item in the Australian current

account?
A. The sale of wool to Italy
B. An Australian consulting company receives payment from an
overseas firm

C. The fees paid by overseas students at an Australian university

D. An Australian company pays for consulting services from an
overseas firm

10

The capital and financial account includes the capital

account and the financial account.
The capital account (is very small and) includes:
Net capital transfers which include (eg) the
cancellation of debts of poor countries and funds
taken in and out by migrants; and
The net acquisition/disposal of non-produced, nonfinancial assets records sales of embassy land or
patents and copyrights etc.

11

The capital and financial account includes the capital

account and the financial account.
The financial account is (the major component and is) divided
between two sectors:
The official sector records the transactions of the
government sector and the Reserve Bank.
The non-official sector records the transactions of private
sector firms, financial institutions and households direct
and portfolio investment balances of net foreign
investment in Australia and Australian investment abroad

12

When an Australian company purchases a timber mill in

Bosnia, from the perspective of Australia this is a(n):
A. import
B. export
C. balance on merchandise trade

D. capital outflow

13

When an Australian company purchases a timber mill in

Bosnia, from the perspective of Australia this is a(n):
A. import
B. export
C. balance on merchandise trade

D. capital outflow

14

If Australia has a $30 billion current account deficit, then

there must be:
A. net capital inflows of $30 billion
B. net capital inflows of -$30 billion
C. no capital inflows or capital outflows

D. net capital outflows of $30 billion

15

If Australia has a $30 billion current account deficit, then

there must be:
A. net capital inflows of $30 billion
B. net capital inflows of -$30 billion
C. no capital inflows or capital outflows

D. net capital outflows of $30 billion

16

Relative domestic and foreign interest rates

Relative riskiness due to

Risk of loss of capital (political risk, default by borrower,
bankruptcy by foreign business)
Exchange rate risk

Expected long term returns

17

Holding constant risk and the real returns available abroad,

lower domestic real interest rates _____ capital inflows,
_____ capital outflows and _____ net capital inflows.
A. increase; increase; increase
B. increase; increase; decrease
C. increase; decrease; increase
D. decrease; increase; decrease

18

Holding constant risk and the real returns available abroad,

lower domestic real interest rates _____ capital inflows,
_____ capital outflows and _____ net capital inflows.
A. increase; increase; increase
B. increase; increase; decrease
C. increase; decrease; increase
D. decrease; increase; decrease

19

In a closed economy, we have seen that national saving

and investment are equal.

In an open economy, where capital flows are possible,

savings from other countries can finance domestic
investments.

Therefore, we can write:

NS + KI = I

Let a country's national saving (NS), investment (I) and net

capital inflows (KI) be given by the following:
NS = 2000 + 2000*r
I = 2500 - 4000*r
KI = -100 + 6000*r
where r is the real interest rate. If this is a closed economy,
what is the equilibrium real interest rate?
A. 0.083

B. 0.050
C. 0.000

D. 0.025
21

Let a country's national saving (NS), investment (I) and net capital
inflows (KI) be given by the following:
NS = 2000 + 2000*r
I = 2500 - 4000*r
KI = -100 + 6000*r
where r is the real interest rate. If this is a closed economy, what is
the equilibrium real interest rate?

A. 0.083

NS = I (no capital inflow)

2000 + 2000r = 2500 4000r
6000r = 500
r = 0.083

B. 0.050
C. 0.000

D. 0.025
22

1.
2.
3.
4.
5.

What is economic growth?

What determines economic growth
How to promote economic growth
Costs/limits to growth?
Developing a model of economic growth

Read: Bernanke Chapter 10 and Chapter 11

23

LRAS2

LRAS1

SRAS

SRAS

AD

Y*1

AD

Y*2
Rightward shift of LRAC

Output

long term growth refers to a rise in living standards,

not the rise in total GDP

material living standards are reflected in GDP per

capita

http://www.smh.com.au/business/theeconomy/australias-gdp-figures-beat-expectations20140305-346c5.html
http://www.smh.com.au/federal-politics/politicalnews/countrys-rich-have-lions-share-of-incomegrowth-20131009-2v8q2.html

25

Figure 10.1 Ratio of real per capita GDP to 1960 real per capita GDP

27

28

29

30

Figure 10.2 Distribution of world real per capita GDP, 2007

Figure 10.3 Average annual growth rates of

real per capita GDP, 19902007, selected
Sub-Saharan African
countries, Australia and the United States

Figure 10.4 Average annual growth

rates in per capita real GDP 19602007
for three of the Asian Tigers

33

Large differences in growth rates

Large differences in real GDP per capita

Small differences in annual growth rates matter

Why

do countries grow at different rates?

Long term growth refers to growth in GDP per

capita

GDP per capita = Y/POP

But, Y/POP = Y/N x N/POP

Where: in long run Y = Y* = real output;

N = number of employed workers

35

Long term growth refers to growth in GDP per

capita

GDP per capita = Y/POP

But, Y/POP = Y/N x N/POP

Where: in long run Y = Y* = real output;

N = number of employed workers
Share of population working
GDP per worker = average labour productivity
36

 Growth

of labour productivity (Y/N)

Growth

of worker/population ratio (N/POP)

Accordingly, real GDP can only grow if:

the average labour productivity grows; and/or

the share of the working population grows.

37

Figure 10.8 Share of the Australian population employed and average productivity,
19642010

 Human

capital per worker

Physical
Land

The

capital per worker

and natural resources per worker

level of technology

Entrepreneurship

and quality of management

Incentives

provided by the taxation and welfare

systems e.g. retirement pension age

Political
Social

and legal environment e.g. property rights

norms e.g. childcare, family size

39

 Age

distribution of the population

- birth rate, death rate, immigration

- http://www.bbc.com/news/magazine-25968269
Long

term trends affecting participation in the labour

force
- Working parents, retirement ages, years in education etc

40

1.
2.
3.
4.
5.

What is economic growth?

What determines economic growth
How to promote economic growth
Costs/limits to growth?
Developing a model of economic growth

Read: Bernanke Chapter 10 and Chapter 11

41

 Human

capital: policies to improve education, training

and research
Physical capital: policies to enhance saving and
increase investment
Level of technology: policies to increase research and
development
Other: sensible regulation, enforcement of property
rights, transparent government and justice system

42

 Costs

of economic growth?: future consumption

possibilities only possible at expense of current consumption

(ie, elderly sacrifice for the young), environmental damage
Limits

to growth?: is economic growth limited due to

environmental impacts and ongoing population growth?

- Environmental concerns consider technological
improvements, higher wealth -> better solutions; use the
market to address mis-pricing of energy sources
- Population growth concerns richer countries have smaller
families

43

Production Function represents the relationship

between
Primary Factors of Production
Labour
Capital
Secondary Factors of Production
Technology
Management Expertise
Skills
Other Factors e.g. infrastructure, political stability etc..

44

Figure 11.1 The production process

 The

production function shows the level of production

associated with different combinations of capital and
labour, holding secondary factors constant

As

well, with inputs of labour and capital constant, it

shows the level of production with different inputs of
secondary factors

46

47

Capital is a key determinant in economic growth.

The real rate of interest in the economy is an

opportunity cost of employing capital.

It is a rate of interest the firm needs to pay if borrowing funds,

or a rate it could receive if it saved those funds instead.

A key question is how much capital the firm

should acquire.
It is determined by the cost-benefit principle.

Figure 11.3 The diminishing marginal productivity of capital

11-49

Fig. 11.4 The demand for capital

Marginal benefit (marginal product of capital)

= Marginal cost (real interest rate)

When using the production function, economists use

labour, l, as the total number of hours or work
supplied.

Individuals decide how much labour they supply by

comparing the benefits of workingthe real wage
received against the cost of workingand choosing the
best alternative to their time.

The factors that affect a firms demand for labour are

similar to the factors that affect a firms choice of the
capital stock.
The benefits to the firm of employing an additional unit of
labour are measured by the marginal revenue product of
labour: MRPl = P x MPl

As with capital, the MPl and MRPl decline due to the

fact that:

successive workers are assigned to the most productive

tasks
the pragmatic problems of adding more staff to fixed capital.

Determines equilibrium
amount of labour

53

The production function shows how firms

combine those primary factors of production
to produce output:

Assumptions on the production function:

Adding more capital to fixed labour increases total

product but decreases marginal productivity.
Adding more labour to fixed capital increases total
product but decreases marginal productivity.
All secondary factors of production, such as
managerial expertise and the skill level of the
labour, remain constant.

Yt = AtKt . Lt(1 )
Y = amount of real output
K = capital stock
L = amount of labour
A = secondary factors of production
0<a<1
a indicates share of capital, 1-a indicates share of labour

55

Yt = AtKt . Lt(1 )
Y = amount of real output
K = capital stock
L = amount of labour
A = secondary factors of production
0<a<1
a indicates share of capital, 1-a indicates share of labour

Production in period t (Yt) depends on the secondary factors of

production in period t (At), multiplied by a function of
the combination of the employment of
capital and labour in period t (Kt and Lt).
56

Based on the observation that the shares of capital income ()

and labour income (1 ) in US national income have been
more or less constant over time

Widely used (around the world) to represent the production

function in empirical work

Has useful properties:

Displays diminishing marginal productivity for both labour
and capital
Features constant returns to scale (ie, if double inputs of K
and L, then output is doubled)

57

Yt = AtKt . Lt(1 )
Let A = 5
= 0.2 , (1 ) = 0.8
L = K = 1 in period t =1
1.

2.

Keeping labour (L) constant at 1, how will output change as

the quantity of capital (K) increases from 1 to 2, 3, 4, 5?
What happens to output when labour and capital each
increase from 1 to 5 ?

58

t=

At

Kt

Lt

Yt = At.Kta.Lt(1-a)

Y1 = 5 x 10.2 x 1(1-0.2) = 5

5.74

0.74

6.23

0.49

6.60

0.37

6.90

0.30

MPk

Diminishing marginal productivity of capital

59

Yt = At.Kta.Lt(1-a)

t=

At

Kt

Lt

Y1 = 5 x 10.2 x 1(1-0.2) = 5

Y1 = 5 x 20.2 x 2(1-0.2) = 10

15

20

25

Constant returns to scale

60

Start with our Cobb-Douglas function:

yt = Atktlt(1 )

Given a 1% increase in the capital stock between one

period and the next, how much will output increase?

We will use the mathematical rule that if Z = X , then

a percentage change in Z = (the percentage change in
X).

yt = kt
yt -1
kt -1

The LHS is the economys rate of growth. The RHS

shows us that if = 0.25 (which is the share of GDP
paid to owners of capital) then a 1% increase in the
capital stock will lead to a 0.25% increase in growth.

The same type of reasoning shows us how output

would change if all else is constant and the labour
supply changes:
yt = (1 ) lt
yt -1
lt -1

If = 0.25 then a 1% increase in the labour supply will

lead to a 0.75% increase in growth.

The secondary factors of production are known

collectively as total factor productivity because they
impact on the ability to transform primary factors
into output.

We can calculate the contribution to growth by:

yt
yt -1

t
= A
At -1

This is a one-to-one relationship: if TFP increased by

1% there would be a 1% increase in growth.

Economic growth occurs either because the capital

stock has grown, the labour supply has grown, or
there has been an improvement in the economys
ability to use labour and capital.

Example: If capital was growing at 4% pa, labour at 1%,

TFP at 1% and = 0.25, we could calculate the
economic growth rate at 2.75%. Capital would have
contributed 0.25 x 4% = 1%, labour 0.75 x 1% = 0.75%
and TFP 1 x 1% = 1%.

In reality, information on capital stock is difficult to

calculate accurately, but is available. Data on labour,
economic growth and the value of are available and
reasonably accurate.

Figure 11.11 Growth accounting, Australia, 1976 to 2009

Figure 11.12 Growth accounting, Japan, the United Kingdom and the United States

Figure 11.13 Growth accounting, the Asian Tigers and the Philippines, 19601994

Highlight factors influencing total factor productivity (TFP)

Education and human capital

Research and development

Political structure

70

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