CHAPTER 1



8

Why Do Economies Grow?

Chapter Summary

Economic growth is a fundamental goal for an economy because increasing real GDP increases income for the economy, leading to a higher standard of living. The chapter shows how economic growth over time affects how we live our lives differently today than we did 200 years ago. Economic growth is measured to see if real GDP is growing or not. This chapter will explore how growth is measured and the policies that the government uses to promote growth. Capital deepening and technological progress will be discussed in detail. The appendix describes the basic growth model put forth by Nobel laureate Robert Solow. Here are the main points of the chapter:

• Per capita GDP varies greatly throughout the world. There is debate about whether poorer countries in the world are converging in per capita incomes to richer countries.

• Economies grow through two basic mechanisms: capital deepening and technological progress. Capital deepening is an increase in capital per worker. Technological progress is an increase in output with no additional increases in inputs.

• Ongoing technological progress will lead to sustained economic growth.

• Various theories try to explain the origins of technological progress and determine how we can promote it. These theories include spending on research and development, creative destruction, the scale of the market, induced inventions, and education and the accumulation of knowledge, including investments in human capital.

• Governments can play a key role in designing institutions that promote economic growth, including providing secure property rights.

Applying the Concepts

After reading this chapter, you should be able to answer these seven key questions:

1. How does economic growth affect social indicators such as child labor?

2. Does economic growth necessarily cause more inequality?

3. How can we use economic analysis to understand the sources of growth in different countries?

4. How much did the information revolution contribute to U.S. productivity growth?

5. How are economic growth and health related to one another?

6. Did cultural factors spark the Industrial Revolution?

7. Why are clear property rights important for economic growth in developing countries?

8.1 Economic Growth Rates

In Chapter 5, economic growth was defined as sustained increases in the real GDP of an economy over a long period of time. Economic growth can be illustrated with the use of the production possibilities curve, as shown in Figure 8.1. To see if economic growth has occurred, we need a means of measurement. There are three forms of measurement, which we discuss next:

• GDP

• Real GDP per capita

• Rule of 70

Since real GDP is the indicator of economic growth, real GDP is a starting point for measuring such growth. A country’s economic growth can be measured from one year to the next using real GDP. If we want to measure how real GDP affects the population, then we need a different measurement. The measurement we use for this purpose is called real GDP per capita. Real GDP per capita is gross domestic product per person adjusted for changes in constant prices. It is the usual measure of living standards across time and between countries.

( If we compare people in the United States who lived in the 18th century to people today, we can see they have different economic conditions. For example, people in the 1700s used the fireplace as a place for cooking meals and keeping warm. People today use the fireplace for warmth and decoration. As income increases, standards of living tend to improve. The more income you have in a country, the more its people can afford. A reason to measure economic growth and understand how to make economic growth happen is to improve standards of living. Comparing countries allows economists and policy makers to decide what policy would improve standards of living.

Another way to measure economic growth over time is to use growth rates. A growth rate is the percentage rate of change of a variable from one period to another. You already used growth rates when you calculated inflation rates. This time you will use real GDP as your measure of growth.

If you wish to know how long it takes for a country to double its real GDP, you can use the rule of 70. The following are the formulas useful for understanding economic growth:

( Study Tip

The best way to get better at calculations is to practice them. Take a moment to practice using the equations below on a few problems at the end of the chapter or on .

( Key Equations

Real GDP per capita = [pic]

Growth rate = g = [pic] where “cy” is the current year and “py” is the previous year.

Rule of 70 = [pic]

Economists use growth rates and real GDP (or GNP) per capita to compare countries’ economic growth. Table 8.1 shows real GNP per capita and growth rate data for various countries. Some people might believe that higher growth rates guarantee higher real GNP per capita. Yet notice in the table that even though some countries have a higher growth rate, their real GNP per capita may be lower than other countries. Comparing both growth rates and real GNP (or GDP) per capita allows economists and policy makers to make better policy decisions.

( Caution!

As you calculate growth rates, the percentage change is always calculated relative to the previous year.

Let’s review an Application that answers one of the key questions we posed at the start of the chapter:

1. How does economic growth affect social indicators such as child labor?

Application 1: Increased Growth Leads to Less Child Labor in Developing Countries

CONTRARY TO WHAT MANY PEOPLE MIGHT THINK, MOST CHILD LABOR OCCURS IN AGRICULTURE, WITH PARENTS AS EMPLOYERS, RATHER THAN IN MANUFACTURING PLANTS. AS THE INCOMES OF THE PARENTS INCREASE, THEY TEND TO RELY LESS ON THEIR CHILDREN AND MORE ON SUBSTITUTES FOR CHILD LABOR, SUCH AS FERTILIZER AND NEW MACHINERY. CAREFUL STUDIES IN VIETNAM REVEALED A SIGNIFICANT DROP IN CHILD LABOR DURING THE 1990S, WITH THE BULK OF THAT DECREASE ACCOUNTED FOR BY HIGHER FAMILY INCOMES.

Convergence is the process by which poorer countries close the gap with richer countries in terms of real GDP per capita. Figure 8.2 demonstrates the relationship between average growth rates from 1870–1979 and per capita income in 1870. The line is plotted through 16 developed nations. Obstfeld and Rogoff found that the higher the average growth rate, the lower the per capita income. This showed the possibility of convergence of lesser developed nations with developed nations. However, modern convergence analysis shows that this may not be the case in modern times.

Let’s review an Application that answers one of the key questions we posed at the start of the chapter:

8. Does economic growth necessarily cause more inequality?

Application 2: Growth Need Not Cause Increased Inequality

NOBEL LAUREATE SIMON KUZNETS SHOWED A RELATIONSHIP BETWEEN ECONOMIC GROWTH AND INEQUALITY. AS A COUNTRY DEVELOPS, INEQUALITY WITHIN A COUNTRY FOLLOWED AN INVERTED “U” PATTERN—IT INITIALLY INCREASED AS A COUNTRY DEVELOPED AND THEN NARROWED OVER TIME. HOWEVER, PIKETTY AND SAEZ CONCLUDE THAT INEQUALITY IS NOT BASED SOLELY ON GROWTH. INEQUALITY—AS MEASURED BY THE INCOME SHARE OF THE TOP 10 PERCENT OF FAMILIES—INCREASED FROM 40 PERCENT AT THE BEGINNING OF THE 1920S TO 45 PERCENT THROUGH THE END OF THE GREAT DEPRESSION. DURING WORLD WAR II, THE SHARE FELL TO 32 PERCENT BY 1944 AND REMAINED AT THAT LEVEL UNTIL THE EARLY 1970S, AT WHICH TIME INEQUALITY BEGAN TO AGAIN INCREASE. ECONOMISTS PIKETTY AND SAEZ INDICATE THAT OTHER FORCES BESIDES ECONOMIC GROWTH MAY CAUSE INEQUALITY. SOCIAL NORMS AND OTHER FACTORS, SUCH AS PERCEIVED FAIRNESS OF COMPENSATION AND THE NATURE OF THE TAX SYSTEM, ALSO PLAY A ROLE. MOREOVER, THE UNITED STATES EXPERIENCE SUGGESTS THAT THESE NORMS CAN CHANGE OVER TIME, EVEN WITHIN THE SAME COUNTRY, REGARDLESS OF GROWTH RATES.

8.2 Capital Deepening

Figure 8.3 demonstrates the classical model you learned about in Chapter 7. In the model, it was assumed that the capital stock (K) was fixed and the labor force (L) could change. Figure 8.3 demonstrates what happens when you have fixed labor force and the capital stock varies. An increase in capital with a fixed labor force will cause the production function to change its position, generating more output, moving from Y1 to Y2. To increase the capital stock, we need to increase investment.

To understand the relationship between investment and saving, we assume a simple domestic economy where only households and firms exist. The output generated in the economy creates the income the economy can spend. Income can either be spent on consumption goods or saved. The two types of goods that can be produced are consumption goods (C) and investment goods (I). Since the amount of consumption spending equals the amount of income spent on consumption goods, savings equals investment. Hence the equations below:

( Key Equations

C + S = Y (Income)

C + I = Y (Output)

S = I

Simply stated, saving funds investment spending. How does investment then affect the capital stock? Consider the stock of capital in a country at the beginning of the year. Additional investment during the year will add to the capital stock. At the same time, the capital stock will decrease due to depreciation. The net effect of investment and depreciation determines the amount of the capital stock at the end of the year. The difference between investment and depreciation is called net investment. In other words, net investment equals gross investment minus depreciation.

( Study Tip

To increase the capital stock, net investment must be greater than zero. In other words, investment must be greater than the amount of worn out capital to increase the capital stock.

( Suppose you own a call center and you have 8 computers. Five of the computers stop working due to use and wear. The other 3 still work. If you wanted to increase the capital stock of your company, you would have to purchase more than 5 computers. The capital stock of an economy works basically the same way. The amount of investment must be larger than the replacement capital to increase the capital stock.

( Caution!

When talking about investment, we are not talking about purchasing financial instruments like stocks and bonds. Investment in economics means purchasing real capital.

Other forces can influence capital deepening such as population growth, government, and trade. Population growth allows the labor force to increase. This means more people are working and producing more output. Yet if the capital stock is constant, then the economy experiences diminishing returns.

[pic]Principle of Diminishing Returns

SUPPOSE THAT OUTPUT IS PRODUCED WITH TWO OR MORE INPUTS AND THAT WE INCREASE ONE INPUT WHILE HOLDING THE OTHER INPUTS FIXED. BEYOND SOME POINT—CALLED THE POINT OF DIMINISHING RETURNS—OUTPUT WILL INCREASE AT A DECREASING RATE.

Diminishing returns occur because there is less capital relative to the growing labor force. This decreases output per worker leading to less output produced.

( Recall the previous call center example. Suppose we have 8 computers, but hire 2 more workers than we have computers. The 2 additional workers can take calls but would have to share the computers with the other 8 workers. We would be able to take more calls in total, but we will do so at a diminishing rate because we have to share the 8 computers.

Government expenditures and taxes affect capital deepening in an economy. On the one hand, tax increases take away from income and thus reduce saving. Reduced savings reduce investment used for capital deepening. On the other hand, tax decreases have the opposite effect on income and can actually contribute to capital deepening. In reality, gross investment does not have to come solely from the private sector. Government expenditures in infrastructure such as roads, sewer treatment plants, or computers increase the capital stock of an economy and contribute to capital deepening.

Foreign trade can have a positive effect on capital deepening. Foreign investment in a domestic economy adds to the capital stock even if it generates a trade deficit. However, trade deficits produced by purchasing consumption goods does not contribute to capital deepening.

( When foreign companies create plants in the United States, it has a positive effect on capital deepening. When Toyota and Nintendo start operations in the United States, they increase United States capital stock as they build plants and equipment.

While capital deepening promotes economic growth, it has its limits. The limits to capital deepening are due to the following:

1. Diminishing returns due to a given labor force.

9. Net investment is zero or less than zero. This means that depreciation exceeds the investment. The capital stock stays the same or decreases.

10. You can’t save all your income. You have to have some consumption goods to live.

8.3 The Key Role of Technological Progress

Technological progress happens when more efficient ways of organizing economic affairs allow an economy to increase output without increasing inputs. Technological progress can take different forms. New inventions, innovations, and new ways of doing things are forms of technological progress.

Nobel laureate Robert Solow created a method to measure technological progress called growth accounting. Using a basic production function, Solow measured the growth of output, labor, and capital in terms of growth rates in percentage terms. Solow added one more variable to the production function, growth rate of technological progress.

( Key Equation: Growth Accounting Equation (See Figure 8.5)

Total output growth = growth due to capital growth + growth due to labor growth + technological progress

In Figure 8.5, Edward Denison used growth accounting to show sources of real GDP growth from 1929–1982. Notice that growth due to technological advance accounts for about 1.02 percent annually.

Growth accounting can be used in another way. Growth accounting can be used to measure growth and sources of growth between two countries.

Let’s review two Applications that answer the key questions we posed at the start of the chapter:

1. How can we use economic analysis to understand the sources of growth in different countries?

Application 3: SOURCES OF GROWTH IN CHINA AND INDIA

CHINA AND INDIA ARE THE TWO MOST POPULOUS COUNTRIES IN THE WORLD AND HAVE ALSO GROWN VERY RAPIDLY IN RECENT YEARS. FROM 1978 TO 2004, GDP IN CHINA GREW AT THE ASTOUNDING RATE OF 9.3 PERCENT PER YEAR WHILE INDIA’S GDP GREW AT A LOWER BUT STILL ROBUST RATE OF 5.4 PERCENT PER YEAR. THE REASON CHINA GREW FASTER THAN INDIA OVER THIS 26-YEAR PERIOD IS THAT CHINA INVESTED MUCH MORE THAN INDIA IN PHYSICAL CAPITAL AND WAS ABLE TO INCREASE ITS TECHNOLOGICAL PROGRESS AT A MORE RAPID RATE.

11. How much did the information revolution contribute to U.S. productivity growth?

Application 4: GROWTH ACCOUNTING AND INFORMATION TECHNOLOGY

• LABOR PRODUCTIVITY IS DEFINED AS OUTPUT PER HOUR OF WORK. U.S. PRODUCTIVITY GROWTH SINCE 1959 IS SHOWN IN FIGURE 8.6. FROM 1973 TO 1993, THE GROWTH OF LABOR PRODUCTIVITY SLOWED IN THE UNITED STATES, BUT THE FIGURE SHOWS THAT PRODUCTIVITY GROWTH HAS INCREASED IN RECENT YEARS, REACHING 2.5 PERCENT FROM 1994 TO 2007. SOME OBSERVERS BELIEVE THE COMPUTER AND INTERNET REVOLUTION ARE RESPONSIBLE FOR THIS INCREASE IN PRODUCTIVITY GROWTH. SKEPTICS WONDER, HOWEVER, WHETHER THIS INCREASE IN PRODUCTIVITY GROWTH IS TRULY PERMANENT OR JUST TEMPORARY. ROBERT GORDON OF NORTHWESTERN UNIVERSITY USED GROWTH ACCOUNTING TO STUDY THE IMPACT OF TECHNOLOGICAL PROGRESS. INITIALLY HE FOUND TECHNOLOGICAL PROGRESS IN THE DURABLE MANUFACTURING SECTOR, PARTICULARLY IN THE COMPUTER INDUSTRY ITSELF. LATER HE FOUND TECHNOLOGICAL PROGRESS IN OTHER SECTORS. OTHER ECONOMISTS HAVE CONFIRMED THESE FINDINGS AND THINK THAT SUCH PROGRESS MAY BE PERMANENT AND NOT TEMPORARY

8.4 What Causes Technological Progress?

Now that we have discussed how technological progress is measured, we have to ask what causes technological progress. There is a variety of causes:

• Research and Development Funding – Governments and large firms play a role in funding research and development. Such funding creates the means for new ideas and innovations. Figure 8.7 shows research and development funding by country.

• Monopolies That Spur Innovation – Monopolies are often created by patents. Patent protection gives incentives for firms to create new ideas and products. This can generate what Joseph Schumpeter called creative destruction. Creative destruction is the view that a firm will try to come up with new products and more efficient ways to produce products to earn monopoly profits. Intellectual property rights protection is required to ensure ongoing invention and innovation.

• The Scale of the Market – Larger markets promote the creation of greater amounts and varieties of goods in an economy. Larger markets promote free trade and technological progress.

• Induced Innovations – Innovations that are designed to reduce costs.

• Education, Human Capital, and the Accumulation of Knowledge – There are two basic ways education contributes to technological advance:

1. Increased knowledge and skills complement our current investments in physical capital

2. Education enables people to produce new ideas, copy ideas, or import them from abroad.

Human capital theory has two implications for economic growth:

1. Not all labor is the same. People differentiate themselves by their education, knowledge, and experience.

2. Health and fitness affects productivity.

Let’s review two Applications that answer the key questions we posed at the start of the chapter:

12. How are economic growth and health related to one another?

Application 5: A Virtuous Circle: GDP and Health

ECONOMIC GROWTH PRODUCED A “VIRTUOUS” CIRCLE. IT INCREASED FOOD SUPPLIES, ENABLING WORKERS TO BECOME MORE PRODUCTIVE AND INCREASE GDP EVEN MORE. ACCORDING TO NOBEL LAUREATE ROBERT FOGEL OF THE UNIVERSITY OF CHICAGO, THE AVERAGE WEIGHT OF ENGLISH MALES IN THEIR THIRTIES WAS ABOUT 134 POUNDS IN 1790—20 PERCENT BELOW TODAY’S AVERAGE. FOGEL HAS ARGUED THAT THESE LOWER WEIGHTS AND HEIGHTS WERE DUE TO INADEQUATE FOOD SUPPLIES AND CHRONIC MALNUTRITION. AS HEALTH CONDITIONS IMPROVED, WORKERS BECAME MORE PRODUCTIVE.

13. Did cultural factors spark the Industrial Revolution?

Application 6: CULTURE AND ECONOMIC GROWTH

IN STUDYING THE ECONOMIC HISTORY OF ENGLAND BEFORE THE INDUSTRIAL REVOLUTION, PROFESSOR GREGORY CLARK FOUND THAT CHILDREN OF THE MORE AFFLUENT MEMBERS OF ENGLISH SOCIETY WERE MORE LIKELY TO SURVIVE THAN THOSE OF THE LESS AFFLUENT. THIS HAD THE EFFECT OF CREATING DOWNWARD MOBILITY FOR THE RICH, WHICH HAD PROFOUND EFFECTS ON ENGLISH SOCIETY. THE CULTURAL HABITS OF THE RICH FILTERED THROUGH THE ENTIRE SOCIETY, AND THESE CHANGES IN CULTURE BECAME SUFFICIENTLY PRONOUNCED FOR A QUALITATIVE CHANGE TO TAKE PLACE IN SOCIETY. INDIVIDUALS WERE NOW ABLE TO TAKE ADVANTAGE OF NEW DEVELOPMENTS IN SCIENCE AND TECHNOLOGY AND EMBRACE NEW TECHNOLOGIES AND SOCIAL CHANGE.

ANOTHER THEORY DESCRIBING HOW ECONOMIC GROWTH OCCURS IS NEW GROWTH THEORY. NEW GROWTH THEORIES ARE MODERN THEORIES OF GROWTH THAT TRY TO EXPLAIN THE ORIGINS OF TECHNOLOGICAL PROGRESS. ECONOMISTS SUCH AS ROBERT LUCAS AND PAUL ROMER DEVELOPED MODELS THAT CONTAINED TECHNOLOGICAL ADVANCE AS ESSENTIAL TO ECONOMIC GROWTH. THE IMPACTS OF RESEARCH AND DEVELOPMENT FUNDING TO BASIC EDUCATION ARE CURRENT AREAS OF RESEARCH IN NEW GROWTH THEORY.

8.5 A Key Governmental Role: Providing the Correct Incentives and Property Rights

As discussed in Chapter 3 and earlier in this chapter (see “Monopolies That Spur Innovation” in section 8.4), protection of property rights is essential to economic growth. Without property right protection, there are no incentives to invest in the future. This is a common problem in the developing world. Governments have a key role in providing property right protection, creating the environment for economic growth. International institutions such as the World Bank have attempted to assist developing nations to grow economically. Yet there have to be incentives for governments to want to provide such protection.

Let’s review an Application that answers one of the key questions we posed at the start of the chapter:

14. Why are clear property rights important for economic growth in developing countries?

Application 7: Lack of Property Rights Hinders Growth in Peru

HERNANDO DESOTO HAS STUDIED THE CONSEQUENCES OF “INFORMAL OWNERSHIP” IN DETAIL. HE ARGUES THAT THROUGHOUT THE DEVELOPING WORLD, PROPERTY IS OFTEN NOT HELD WITH CLEAR TITLES. WITHOUT CLEAR EVIDENCE OF OWNERSHIP, THESE OWNERS ARE NOT WILLING TO MAKE LONG TERM INVESTMENTS TO IMPROVE THEIR LIVES. BUT THERE ARE OTHER IMPORTANT CONSEQUENCES AS WELL. ECONOMISTS RECOGNIZE THAT STRONG CREDIT SYSTEMS—THE ABILITY TO BORROW AND LEND EASILY—ARE CRITICAL TO THE HEALTH OF DEVELOPING ECONOMIES. BUT WITHOUT CLEAR TITLE, PROPERTY CANNOT BE USED AS COLLATERAL (OR SECURITY) FOR LOANS. AS A CONSEQUENCE, THE POOR MAY IN FACT BE LIVING ON VERY VALUABLE LAND, BUT BE UNABLE TO BORROW AGAINST THAT LAND TO START A NEW BUSINESS.

Activity

Use the equations presented earlier in this chapter and the following data to compute the missing data:

|Country |Real GDP, 2007 |Real GDP, 2008 |Population |Real GDP per Capita, |Growth Rate |

| | | | |2008 | |

|Astoria |$20 trillion |$24 trillion |1 billion | | |

|Byzantium |$15 trillion |$12 trillion |500 million | | |

Answers

|Country |Real GDP, 2007 |Real GDP, 2008 |Population |Real GDP per Capita, |Growth Rate |

| | | | |2008 | |

|Astoria |$20 trillion |$24 trillion |1 billion |$24,000 |20% |

|Byzantium |$15 trillion |$12 trillion |500 million |$24,000 |-20% |

Key Terms

Capital deepening: Increases in the stock of capital per worker.

Convergence: The process by which poorer countries close the gap with richer countries in terms of real GDP per capita.

Creative destruction: The view that a firm will try to come up with new products and more efficient ways to produce products to earn monopoly profits.

Growth accounting: A method to determine the contribution to economic growth from increased capital, labor, and technological progress.

Growth rate: The percentage rate of change of a variable from one period to another.

Human capital: The knowledge and skills acquired by a worker through education and experience and used to produce goods and services.

Labor productivity: Output produced per hour of work.

New growth theory: Modern theories of growth that try to explain the origins of technological progress.

Real GDP per capita: Gross domestic product per person adjusted for changes in constant prices. It is the usual measure of living standards across time and between countries.

Rule of 70: A rule of thumb that says output will double in 70/x years, where x is the percentage rate of growth.

Saving: Income that is not consumed.

Technological progress: More efficient ways of organizing economic affairs that allow an economy to increase output without increasing inputs.

Appendix – A Model of Capital Deepening

( Study Tip

We are building models again. The parts of the model are the production function, the savings function and depreciation. Put these parts together by drawing each as you review this appendix.

The model of capital deepening discussed in the appendix is a simple growth model developed by Robert Solow. The model provides a graphical framework to understand capital deepening and technological progress. We will assume constant population and no government or foreign sector. We will look at savings, depreciation, and capital deepening.

The first step of the model is to develop a production function between capital and output. Remember that population growth is constant, thus causing the production function to show diminishing returns.

[pic]Principle of Diminishing Returns

SUPPOSE OUTPUT IS PRODUCED WITH TWO OR MORE INPUTS AND WE INCREASE ON INPUT WHILE HOLDING THE OTHER INPUTS FIXED. BEYOND SOME POINT—CALLED THE POINT OF DIMINISHING RETURNS—OUTPUT WILL INCREASE AT A DECREASING RATE.

Figure 8A.1 shows the production function with diminishing returns to capital. What causes this production function to increase? Gross investment must exceed depreciation.

( Remember

To increase the capital stock, net investment must be greater than zero.

For this to happen, saving must be greater than depreciation. A fraction of our income (Y) can be saved.

( Caution!

The saving function should always be below the production function. You can’t save more than your income earned.

Figure 8A.2, panel A, shows the relationship between the production function and saving. Saving will always be under the production function since a nation can’t save all its income. The last item we need to complete the model is depreciation. Figure 8A.2, panel B, shows depreciation as a function of the capital stock. Larger capital stock, given a constant rate of depreciation, will cause depreciation to increase. With saving and depreciation defined, we can see how changes in the capital stock occur.

( Key Equations

Saving = S = sY

Where

S = total saving

s = saving rate

Y = total income

Depreciation = dK

Where

d = depreciation rate

K = capital stock

Change in Capital Stock = Saving – Depreciation = sY– dK

( Study Tip

To increase the capital stock, net investment must be greater than zero. With that in mind, sY – dK > 0.

Figure 8A.3 shows the basic Solow Growth Model. By combining the features we just described—A and B—we can see graphically how an economy would grow through capital deepening to its long-run equilibrium. As long as saving is greater than depreciation, you will grow your capital stock, or in other words, experience capital deepening. Capital deepening allows more capital per worker, leading to greater output per worker, increasing output. This leads to higher real wages.

The economy will continue to capital deepen until saving equals depreciation and the economy reaches its long-run equilibrium. It may take some time for a nation to reach this point. Can the economy change its long-run equilibrium? Yes, by increasing the saving rate.

By increasing the saving rate, you increase investment. This will cause saving to be greater than depreciation and thus you can increase your capital stock to a new long-run equilibrium. This concept is demonstrated in Figure 8A.4. By increasing the saving rate, the saving curve increased, shifting upwards from s1Y to s2Y. Depreciation stayed in its position since there was no variable change in depreciation. Point e1, the original long-run equilibrium, is no longer the long-run equilibrium since saving is greater than depreciation. Capital deepening will continue along s2Y until it reaches the new long-run equilibrium, e2. The capital stock increased from K1 to K2.

Another way to increase capital deepening is technological progress. Technological progress increases output without changing inputs to production. Saving increases as income increases as shown in Figure 8A.5, shifting the saving rate upward, allowing for more capital deepening.

( Study Tip

The only way to get better at graphs is to draw them. You should draw and label this graph in Figure 8A.5 enough times that it becomes comfortable to you.

Basic Points of the Solow Growth Model

1. Capital deepening, an increase in the stock of capital per worker, will occur as long as total saving exceeds depreciation. As capital deepening occurs, there will be economic growth and increased real wages.

15. Eventually, the process of capital deepening will come to a halt as depreciation catches up with total saving.

16. A higher saving rate will promote capital deepening. If a country saves more, it will have higher output. But eventually, the process of economic growth through capital deepening alone comes to an end, even though this may take decades to occur.

17. Technological progress not only directly raises output, but it also allows capital deepening to occur.

Practice Quiz

(Answers are provided at the end of the Practice Quiz.)

1. The ability to produce more output without using any more inputs is called

a. capital deepening.

b. technological progress.

c. human capital.

d. investment.

2. If a country’s real GDP is growing at a rate of 5 percent per year, how long will it take for the real GDP to double?

a. 20 years

b. 14 years

c. 12 years

d. 7.5 years

3. GDP per capita in 2004, and the per capita growth rate from 1960 until 2004 for the United States were, respectively

a. $39,170 and 2.19%.

b. $30,040 and 4.10%.

c. $27,860 and 3.00%.

d. $31,460 and 2.46%.

4. This question tests your understanding of Application 1 in this chapter: Increased growth leads to less child labor in developing countries. How does economic growth affect social indicators such as child labor?

Dartmouth economists Eric V. Edmonds and Nina Pavcnik have studied the factors that lead to changes in child labor in developing countries.

Which of the following assertions is consistent with their findings?

a. Most child labor occurs in manufacturing plants, not in agriculture.

b. Child labor is commonly found across the social strata in developing countries. Changes in the income of the parents do not seem to influence the use of child labor.

c. Child labor is a phenomenon closely associated with extreme poverty.

d. Over time, as developing economies grow, child labor tends to be widespread.

5. Refer to the figure below. Each dot represents one country. The conclusion drawn from the study associated with this graph is that

[pic]

a. lower growth rates of output result in lower per capita income.

b. since 1870, we have been unable to establish a relationship between growth rates and per capita income.

c. countries with higher levels of GDP in 1870 grew more slowly than countries with lower levels of GDP.

d. the income of persons who earned 2,000 in 1870 grew at a slower rate than the income of persons who earned less income.

6. If a firm increases its use of capital while holding constant the number of workers employed, the firm is said to experience

a. capital augmentation.

b. investment deepening.

c. labor intensity.

d. capital deepening.

7. Which of the following statements is entirely correct?

a. The stock of capital increases with any gross investment or depreciation.

b. As capital grows, depreciation also grows, eventually catching up to the level of gross investment, and putting a stop to the growth of capital deepening.

c. In order for the stock of capital to increase, gross investment must exceed savings.

d. all of the above

8. The impact of population growth on capital deepening is an illustration of a key principle of economics. Which one?

a. the principle of creative destruction

b. the principle of the new growth model

c. the real-nominal principle

d. the principle of human capital

9. When a country experiences a trade deficit, which of the following helps in the process of capital deepening?

a. trade deficits that fund current consumption

b. the export of investment goods

c. borrowing in order to finance the import of investment goods

d. all of the above

10. The role of technological progress in economic growth can be described as follows:

a. Technological progress does not cause real GDP to rise, rather it shifts what goods the economy makes.

b. Technological progress will be beneficial only if the population also grows as real GDP grows.

c. Per capita output will rise when we discover new and more effective uses of capital and labor.

d. all of the above

11. Consider the following relationship: Y = f(K, L, A). To measure technological progress, we do the following:

a. We observe increases in K, L, and Y.

b. We observe the impact of changes in A on K and L.

c. We observe changes in Y by studying changes in K, L, and A.

d. We observe changes in K and L to establish the magnitude of the ratio K/L.

12. This question tests your understanding of Application 3 in this chapter: Sources of growth in China and India. How can we use economic analysis to understand the sources of growth in different countries?

“China and India are the two most populous countries in the world and have also grown very rapidly in recent years. From 1978 to 2004, GDP in China grew at the astounding rate of 9.3 percent per year while India’s GDP grew at a lower but still robust rate of 5.4 percent per year.”

Why did China grow faster than India over this 26-year period??

a. China invested much more than India in physical capital and was able to increase its technological progress at a more rapid rate.

b. Employment in China grew at a much faster rate than in India, and this resulted in a faster growth rate.

c. China experienced a much larger increase in human capital than did India, and this accounted for the more rapid rate of growth.

d. China’s economic system moved more toward capitalism than did India’s, and this was responsible for the faster rate of growth.

13. Suppose the growth rate of GDP in the United States is 2.9 percent. If 1.2 percent and 0.9 percent are due, respectively, to capital and labor growth, the amount resulting from technological progress is

a. 1.0 percent.

b. 5.0 percent.

c. 0.8 percent.

d. 2.1 percent.

14. Refer to the figure below. Which of the following statements is correct?

[pic]

a. At the capital usage point K0, the capital stock of the country is falling.

b. At the capital usage point K1, the capital stock of the country is rising at a faster rate than at K0.

c. At the capital usage point K1, the capital stock of the country is rising, but at a slower rate than at K0.

d. At the capital usage point K*, the capital stock of the country is rising, but at a faster rate than at K0 or K1.

15. All of the following encourage increases in technological progress EXCEPT

a. the possibility of monopoly profits.

b. closed economies.

c. larger markets through free trade.

d. the ability to patent a new invention.

16. This question tests your understanding of Application 4 in this chapter: Growth accounting and information technology. How did the emergence of the Internet affect economic growth in the United States?

“U.S. productivity growth climbed in the last half of the 1990s. Some observers believe the computer and Internet revolution are responsible for the increase in productivity growth. Skeptics wonder, however, whether this increase in productivity growth is truly permanent or just temporary. Higher investment in computer technology began in the mid-1980s, but until recently there was little sign of increased productivity growth. Had the investment in information technology finally paid off?”

The studies conducted by Robert J. Gordon of Northwestern University, and those of other economists using growth accounting methods to shed light on this issue, found that

a. Increases in technological progress are largely confined to the durable goods manufacturing industry, including the production of computers itself.

b. Productivity growth was rapid in the late 1990s, but it began to slow down during the recessionary period at the beginning of this century.

c. Technological progress has been more widespread throughout the economy than originally suspected, suggesting that the increase is likely to be permanent.

d. If productivity growth continues at its current rate, we will likely suffer from less rapid economic growth in the United States and across the globe.

17. The process by which competition for monopoly profits leads to technological progress is called

a. creative destruction.

b. monopolistic creativity.

c. destructive creation.

d. creative monopolization.

18. According to human capital theory, all of the following help make workers more productive EXCEPT

a. education

b. health and fitness

c. skills

d. increased unemployment benefits

19. Explain how government spending and taxation affect the process of capital deepening.

20. Explain how the foreign sector affects the process of capital deepening.

21. List the sources of output growth, and describe how growth accounting explains where growth comes from.

22. Different sources of economic growth have different implications for future growth. Which source allows households to consume more now and in the future?

23. An increase in real wages occurs when output per worker increases. Then, what causes an increase in output per worker?

24. Specifically, how does education contribute to economic growth?

Answers to the Practice Quiz

1. b. Economists believe that there are two basic mechanisms that increase GDP per capita over the long term. One is capital deepening: an increase in the economy’s stock of capital—plant and equipment—relative to its workforce. The other is technological progress: the ability to produce more output without using any more inputs—capital or labor.

2. b. Using the Rule of 70, the number of years for real GDP to double = 70 / Percentage growth rate = 70 / 5 = 14 years.

3. a. The United States has the largest GDP per capita among the countries listed.

4. c. Child labor is a phenomenon closely associated with extreme poverty. Over time, as economies grow, child labor will tend to disappear.

5. c. The relationship between growth rates and per capita income in 1870 is downward-sloping. Countries with higher levels of GDP in 1870 grew more slowly than countries with lower levels of GDP.

6. d. Capital deepening is an increase in the stock of capital per worker.

7. b. This is how the process of capital deepening occurs.

8. b. With less capital per worker, output per worker will also tend to be less because each worker has fewer machines to use. This is an illustration of the principle of diminishing returns.

9. c. An economy can run a trade deficit and import investment goods to aid capital deepening. It can finance the purchase of those goods by borrowing, and as investment rises, GDP and economic wealth rises and the country can afford to pay back the borrowed funds. Trade deficits that fund current consumption do not aid in the process of capital deepening.

10. c. Technological progress, or the birth of new ideas, is what makes us more productive. Per capita output will rise when we discover new and more effective uses of capital and labor.

11. a. Increases in A represent technological progress, or more output produced from the same level of inputs, K and L. We can measure technological progress indirectly by observing increases in capital, labor, and output.

12. a. China invested much more than India in physical capital, and this allowed it to increase its technological progress at a more rapid rate.

13. c. GDP growth is due to capital growth, labor growth and technological progress.

14. c. The difference between sY and dK is smaller at K1 than at K0, so the increase in the capital stock will be smaller.

15. b. Closed economies will tend to inhibit increases in technological progress.

16. c. It took a substantial period of time before businesses began to harness the use of modern computer technology and the Internet. Today, however, the growth of productivity is high, and if it does continue at its current high rate, we will enjoy more rapid economic growth in the United States and across the globe.

17. a. The process by which competition for monopoly profits leads to technological progress is called creative destruction by Schumpeter. By allowing firms to compete to be monopolies, society benefits from increased innovation.

18. d. Human capital is an investment in human beings—in their knowledge, skills, and health.

19. When the government taxes the private sector to engage in consumption spending, it takes away some of the household savings, which could have been used for capital deepening. Therefore, taxation destined for government consumption reduces total investment in the economy and capital deepening. When the government taxes the private sector to engage in government investment expenditures, such as roads, buildings, and airports, the government is directly contributing to the process of capital deepening. Since people finance part of their taxes by reducing consumption and part by reducing savings, when the government uses the tax revenue for investment purposes it actually diverts more of national income to investment than was invested by the private sector.

20. If a country runs a trade deficit (or buys more than it sells abroad) to acquire consumer goods, the country would be borrowing from abroad, but there would be no additional capital deepening, therefore, no additional future output growth to help pay the funds back. On the other hand, if the country runs a trade deficit to import investment goods, the deficit is valuable to the economy because it contributes to the process of capital deepening. The country will be able to pay the funds borrowed once economic growth raises GDP.

21. The sources of economic growth are labor growth, capital growth, and technological growth. Growth accounting explains the contributions to economic growth from each of these sources by observing increases in capital, labor, and output over a given period. Using these, we can measure technological progress indirectly. We first ask how much of the change in output can be explained by contributions from the changes in capital and labor, then, whatever growth cannot be explained must have been caused by increases in technological progress.

22. When growth comes from increases in investment in capital and labor, growth must be supported by a high rate of saving. In contrast, when growth comes from technological progress, consumers can consume, not save, a higher fraction of GDP. Therefore, contributions by technological progress allow a higher level of consumption today. This is also true in the future. There are natural limits to growth through the process of capital deepening. Technological progress has better growth prospects than capital deepening.

23. Output per worker will rise when workers acquire better skills and knowledge (human capital). Output per worker also rises with an increase in private investment. Additions of physical capital result in an increase in the productivity of labor. Government investment, in roads, bridges, and public works (social capital) also raises the productivity of labor in the same manner as private investment in physical plant and equipment does.

24. Education contributes to economic growth in two ways. First, investment in human beings complements investment in physical capital. New growth theory is a field of economics that studies how incentives for research and development, for example, interact with the accumulation of physical capital. Second, education enables the workforce to use its skills and knowledge to develop new ideas, or to import ideas from abroad. The adoption of ideas requires an educated workforce to tap into this knowledge.

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