Potential GDP and Economic Growth

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Why are some nations rich

and others poor?

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17When you have completed your study of this chapter, you will be able to

1 Explain what determines potential GDP.

2 Define and calculate the economic growth rate, and explain the implications of sustained growth.

3 Explain the sources of labor productivity growth.

4 Describe policies that speed economic growth.

CHAPTER CHECKLIST

Potential GDP and Economic Growth

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MACROECONOMIC APPROACHES AND PATHWAYS

The Three Main Schools of ThoughtThe three main approaches to macroeconomics are based on three schools of thought:

• Classical macroeconomics• Keynesian macroeconomics• Monetarist macroeconomics

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Classical Macroeconomics

According to classical macroeconomics, the market economy works well and delivers the best available macroeconomic performance.

Aggregate fluctuations are a natural consequence of an expanding economy with rising living standards.

Government intervention can only hinder the ability of the market to allocate resources efficiently.

MACROECONOMIC APPROACHES AND PATHWAYSMACROECONOMIC APPROACHES AND PATHWAYS

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Classical macroeconomics fell into disrepute during the 1930s, which was a decade of high unemployment and stagnant production throughout the world.

Great Depression is a decade (the 1930s) of high unemployment and stagnant production throughout the world economy.

Classical macroeconomics predicted that the Great Depression would end but gave no method for ending it more quickly.

MACROECONOMIC APPROACHES AND PATHWAYSMACROECONOMIC APPROACHES AND PATHWAYS

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Keynesian Macroeconomics

According to Keynesian macroeconomics, the market economy is inherently unstable and it requires active government intervention to achieve full employment and sustained economic growth.

John Maynard Keynes, in his book “The General Theory of Employment, Interest, and Money,” began this school of thought.

Keynes’ theory was that too little consumer spending and investment led to the Great Depression.


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Keynes’ solution to depression and high unemployment was increased government spending.

But Keynes predicted that his policy aimed at curing unemployment in the short term might increase it in the long term.

This prediction became reality during the 1960s and 1970s, when inflation exploded, growth slowed, and unemployment increased.

The global recession of 2008–2009 and fear of another great depression revived interest in Keynesian ideas.


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Monetarist Macroeconomics

According to monetarist macroeconomics, the classical view of the world is broadly correct, but in addition to fluctuations that arise from the normal functioning of an expanding economy, fluctuations in the quantity of money also generate the business cycle.

A slowdown in the growth rate of money brings recession and a large decrease in the quantity of money brought the Great Depression.

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Milton Friedman was the most prominent monetarist.

The view that monetary contractions are the sole source of recessions is held by few economists today.

But the view that the quantity of money plays a role in economic fluctuations is accepted by all economists and is part of today’s consensus.


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Today’s Consensus

Each of the earlier schools provides insights and ingredients that survive in today’s consensus.

Classical macroeconomics provides the story of the economy at or close to full employment.

But the classical approach doesn’t explain how the economy performs in the face of a major slump in spending.


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Keynesian macroeconomics takes up the story in a recession or depression.

When spending is cut, the demand for most goods and services and the demand for labor decrease.

Prices and wage rates don’t fall, but the quantity of goods and services sold and the quantity of labor employed do fall and the economy goes into recession.

In a recession, an increase in spending by governments, or a tax cut that leaves people with more of their earnings to spend, can help to restore full employment.


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Monetarist macroeconomics elaborates the Keynesian story by emphasizing that a contraction in the quantity of money brings higher interest rates and borrowing costs, which are a major source of cuts in spending that bring recession.

Increasing the quantity of money and lowering the interest rate in a recession can help to restore full employment.

And keeping the quantity of money growing steadily in line with the expansion of the economy’s production possibilities can help to keep inflation in check and can also help to moderate the severity of a recession.


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Another component of today’s consensus is the view that the long-term problem of economic growth is more important than the short-term problem of recessions.

Even a small slowdown in economic growth brings a huge cost in terms of a permanently lower level of income per person.

The Road Ahead

We follow the new consensus and begin with an explanation of what determines potential GDP and the pace at which it grows.


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17.1 POTENTIAL GDP

Potential GDP is the value of real GDP when all the economy’s factors of production are fully employed.

We produce the goods and services that make up real GDP by using factors of production: labor and human capital, physical capital, land, and entrepreneurship.

At any given time, the quantities of human capital, physical capital, land, entrepreneurship, and the state of technology are fixed.

But the quantity of labor is not fixed.

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17.1 POTENTIAL GDP

The quantity of labor employed depends on the choices of people and businesses.

So real GDP produced depends on the quantity of labor employed.

To describe the relationship between real GDP and the quantity of labor employed, we use a relationship called the production function.

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17.1 POTENTIAL GDP

The Production Function

Production function is a relationship that shows the maximum quantity of real GDP that can be produced as the quantity of labor employed changes and all other influences on production remain the same.

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17.1 POTENTIAL GDP

Figure 17.1 shows the production function.

100 billion hours of labor can produce $11 trillion of real GDP at point A.

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17.1 POTENTIAL GDP

300 billion hours of labor can produce $20 trillion of real GDP at point C.

200 billion hours of labor can produce $16 trillion of real GDP at point B.

The production function PF is a limit to what is attainable.

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17.1 POTENTIAL GDP

The production function displays diminishing returns: The tendency for each additional hour of labor employed to produce successively smaller additional amounts of real GDP.

The production function is a boundary between the attainable and the unattainable.

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17.1 POTENTIAL GDP

The Labor Market

The Demand for Labor

Quantity of labor demanded is the total labor hours that all the firms in the economy plan to hire during a given time period at a given real wage rate.

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17.1 POTENTIAL GDP

Demand for labor is the relationship between the quantity of labor demanded and real wage rate when all other influences on firms’ hiring plans remain the same.

The lower the real wage rate, the greater is the quantity of labor demanded.

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17.1 POTENTIAL GDP

The Supply of Labor

Quantity of labor supplied is the number of labor hours that all the households in the economy plan to work during a given time period and at a given real wage rate.

Supply of labor is the relationship between the quantity of labor supplied and the real wage rate when all other influences on work plans remain the same.

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17.1 POTENTIAL GDP

The real wage rate influences the quantity of labor supplied because what matters to people is not the number of dollars they earn but what those dollars will buy.

The quantity of labor supplied increases as the real wage rate increases for two reasons:

• Hours per person increase.

• Labor force participation increases.

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17.1 POTENTIAL GDP

Labor Market Equilibrium

The price of labor services is the real wage rate.

A rise in the real wage rate eliminates a shortage of labor by decreasing the quantity demanded and increasing the quantity supplied.

A fall in the real wage rate eliminates a surplus of labor by increasing the quantity demanded and decreasing the quantity supplied.

The labor market is in equilibrium when there is no shortage or surplus of labor.

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17.1 POTENTIAL GDP

Figure 17.2(a) shows labor market equilibrium.

1. Full employment occurs when the quantity of labor demanded equals the quantity of labor supplied.

2. Equilibrium real wage rate is $50 an hour.

3. Full-employment quantity of labor is 200 billion hours a year.

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17.1 POTENTIAL GDP

Full Employment and Potential GDP

When the labor market is in equilibrium, the economy is at full employment.

When the economy is at full employment, real GDP equals potential GDP.

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17.1 POTENTIAL GDP

Figure 17.2(b) shows potential GDP.

1. When the full-employment quantity of labor is 200 billion hours a year,

2. Potential GDP is $16 trillion.

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17.2 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

Economic growth rate is the annual percentage change of real GDP.

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To calculate this growth rate, we use the formula:

Growth of real GDP =

Real GDP in current year

Real GDP in previous yearx 100

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 real GDP =

$8.4 trillion – $8.0 trillion

$8.0 trillionx 100 = 5 percent.

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The standard of living depends on real GDP per person.

Real GDP per person is real GDP divided by the population.

The contribution of real GDP growth to the change in the standard of living depends on the growth rate of real GDP per person.

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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.

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Use these two values of real GDP per person in the growth formula to calculate the growth rate of real GDP per person. It is

Growth rate of real GDP per person

$41,584 – $40,000

$40,000x 100 = 4 percent.=

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The growth rate of real GDP per person can also be calculated by using the formula:

Growth of real GDP per person

Growth rate of real GDP

Growth rate of population

– =

Growth of population

202 million – 200 million

200 millionx 100 = 1 percent.=

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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.

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

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The Magic of Sustained Growth

Sustained growth of real GDP per person can transform a poor society into a wealthy one. The reason is that economic growth is like compound interest.

Rule of 70 is the number of years it takes for the level of any variable to double, which is approximately 70 divided by the annual percentage growth rate of the variable.

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Table 17.1 Growth Rates

Growth rate Years for level(% per year) to double Example

2 35 U.S. real GDP per person

7 10 China real GDP per person

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17.3 LABOR PRODUCTIVITY 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.

Real GDP growth contributes to improving our standard of living.

But our standard of living improves only if we produce more goods and services with each hour of labor.

So our main concern is to understand what makes labor more productive.

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Labor Productivity

Labor productivity is the quantity of real GDP produced by one hour of labor.

It is calculated by using the formula:

Aggregate hoursLabor productivity =

Real GDP

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For example, if real GDP is $8,000 billion and aggregate hours are 200 billion, then we can calculate labor productivity as

200 billionLabor productivity =

$8,000 billion= $40 per hour

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When labor productivity grows, real GDP per person grows, so the growth in labor productivity is the basis of rising living standards.

The growth of labor productivity depends on two things:• Saving and investment in physical capital• Expansion of human capital and discovery of new

technologies

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Saving and Investment in Physical Capital

Saving and investment in physical capital increase the capital per worker and increase labor productivity.

But additional capital will not bring sustained economic growth because the law of diminishing returns applies to capital:

If the quantity of capital is small, an increase in capital brings a large increase in production; and

If the quantity of capital is small, an increase in capital brings a large increase in production.

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Figure 17.3 illustrates the relationship between capital and labor productivity.

The curve PC is the productivity curve.

1. With a small amount of capital an increase in the capital brings a large increase in real GDP per hour of labor.

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2. With a large amount of capital, an increase in the capital brings a small increase in real GDP per hour of labor.

If capital per hour of labor keeps increasing, labor productivity increases by ever smaller amounts and eventually stops rising.

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Expansion of Human Capital and Discovery of New TechnologiesHuman capital—the accumulated skill and knowledge of people—comes from three sources:

• Education and training• Job experience• Health and diet

Expansion of human capital and the discovery of new technologies has increased labor productivity.

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The discovery of new technologies has made an even greater contribution to economic growth than the growth of physical capital and the expansion of human capital.

Combined Influences Bring Labor Productivity Growth

To reap the benefits of technological change, capital must increase.

Some of the most powerful and far-reaching technologies are embodied in human capital, but most technologies are embodied in physical capital.

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Figure 17.4 illustrates the effects of increased human capital and technological change.

The curve PC0 is the

productivity curve in 1960.

$180 of capital per hour of labor produced $40 of goods and services—real GDP per hour of labor.

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The curve PC1 is the

productivity curve in 2010.

$180 of capital per hour of labor produced $80 of goods and services—real GDP per hour of labor.

The expansion of human capital and discovery of new technologies shift the PC curve upward and are not subject to diminishing returns.

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Figure 17.5 illustrates how labor productivity grows.

In 1960, workers had $80 of capital per hour of labor and produced $25 of real GDP per hour of labor.

1. When capital increased to $180 per hour of labor in 2010, real GDP per hour of labor increased to $40.

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2. The expansion of human capital and discovery of new technologies shifted the productivity curve upward to PC1 and …

increased real GDP per hour of labor to $80.

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Real GDP grows because labor becomes more productive and because the quantity of labor increases.

Figure 17.6 summarizes the sources of real GDP growth.

Real GDP growth depends on quantity of labor growth and on labor productivity growth.

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Quantity of labor growth depends on• Population growth• The labor force participation rate• Average hours per worker

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Labor productivity growth depends on• Physical capital growth• Human capital growth• Technological advances

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17.3 ECONOMIC GROWTH THEORIES: OLD AND NEW

What Keeps Labor Productivity Growing?

Labor productivity keeps growing because of the choices people make in the pursuit of profit.

The new theory of economic growth emphasizes three facts about market economies:

• Human capital grows because of choices.• Discoveries result from choices.• Discoveries bring profit, and competition destroys

profit.

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Human Capital Expansion and Choices

People decide how long to remain in school, what to study, and how hard to study.

Discoveries and Choices

The pace at which new discoveries are made—and at which technology advances—is not determined by chance.

The pace at which new discoveries are made depends on how many people are looking for a new technology and how intensively they are looking.

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Discoveries and Profits

The forces of competition squeeze profits, so to increase profit, people constantly seek either lower cost methods of production or new and better products for which people are willing to pay a higher price.

Two other facts play a key role in the new growth theory:

• Many people can use discoveries at the same time.

• Physical activities can be replicated.

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1. People want a higher standard of living and are spurred by...

2. Profit incentives to make the...

3. Innovations that lead to...

Figure 17.7 illustrates new growth theory in terms of a perpetual motion machine.

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4. New and better techniques and new and better products, which in turn lead to...

5. The birth of new firms and the death of some old firms,

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The result is...

8. A higher standard of living.

But people want a yet higher standard of living, and the growth process continues.

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17.4 ACHIEVING FASTER GROWTH

Preconditions for Economic Growth

Economic freedom is the fundamental precondition for creating the incentives that lead to economic growth.

Economic freedom is a condition in which people are able to make personal choices, their private property is protected, and they are free to buy and sell in markets.

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Economic freedom requires the protection of private property—the factors of production and goods that people own.

Property rights are the social arrangements that govern the protection of private property.

Economic freedom also requires free markets.

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Policies to Achieve Faster Growth

To achieve faster economic growth, we must increase• The growth rate of capital per hour of labor or• The growth rate of human capital or• The pace of technological advance.

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The main actions that governments can take to achieve these objectives are

• Create incentive mechanisms• Encourage saving• Encourage research and development• Encourage international trade• Improve the quality of education

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Create Incentive Mechanisms

Economic growth occurs when the incentive to save, invest, and innovate is strong enough. These incentives exist only when private property is protected.

Encourage Saving

Saving finances investment, which brings capital accumulation.

Tax incentives can encourage saving, increase the growth of capital, and stimulate economic growth.

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Encourage Research and Development

Everyone can use the fruits of basic research and development efforts.

Because basic inventions can be copied, the inventor’s profit is limited and so the market allocates too few resources to this activity.

Governments can direct public funds toward financing basic research, but it requires a mechanism for allocating public funds to their highest-valued use.

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Encourage International Trade

Free international trade stimulates economic growth by extracting all the available gains from specialization and trade.

Improve the Quality of Education

By funding basic education and by ensuring high standards in skills such as language, mathematics, and science, governments can contribute enormously to a nation’s growth potential.

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How Much Difference Can Policy Make?

A well-intentioned government cannot dial up a big increase in the growth rate.

But it can pursue policies that will nudge the growth rate upward.

And over time, the benefits from these policies will be large.

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Political stability, property rights protected by the rule of law, limited government intervention in markets are …

The key features of the economies that enjoy high incomes and they are the features missing in those that remain poor.

Most of the rich nations have experienced sustained economic growth over many decades.

Europe’s Big 4 economies (France, Germany, Italy, and the United Kingdom) have been enjoying economic growth for 200 years.

The United States started to grow rapidly 150 years ago and overtook Europe in the early 20th century.

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In the past 50 years, the gaps between these countries haven’t changed much.

In a transition from Communism to a market economy, Central Europe is now growing faster.

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Economic growth in Central and South America and Africa has been persistently slow.

The gap between the United States and these regions has widened.

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Real GDP per person in East Asian economies has converged toward that in the United States.

These economies are like fast trains running on the same track at similar speeds with roughly constant gaps.

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Hong Kong and Singapore are the lead trains and run about

15 years in front of Taiwan,

20 years in front of South Korea, and

almost 40 years in front of China.

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Between 1960 and 2010,

Hong Kong and Singapore transformed themselves from poor developing economies to take their places among the world’s richest economies.

Potential GDP and Economic Growth

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