MACROECONOMICS I
Production and Growth
Lecture 3
February 25, 2022
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PREVIOUSLY IN MACROECONOMICS:
• What is Gross Domestic Product (GDP)?
• What are the components of GDP?
• How is GDP corrected for inflation?
• What is the Consumer Price Index (CPI)?
How is it calculated? What’s it used for?
• What are the problems with the CPI? How serious
are they?
• How does the CPI differ from the GDP deflator?
• How can we correct interest rates for inflation?
TODAY:
• What are the facts about living standards and
growth rates around the world?
• Why does productivity matter for living
standards?
• What determines productivity and its growth rate?
• How can public policy affect growth and living
standards?
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A PICTURE IS WORTH A THOUSAND STATISTICS
A typical family with all their possessions in the U.K., an advanced economy.
GDP per capita
= $39,040
Child mortality
rate = 0.4%
Access to
modern sanitation
facilities = 100%
Educational attainment =60% enrolled in higher education
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A PICTURE IS WORTH A THOUSAND STATISTICS
A typical family with all their possessions in Mexico, a middle income country
GDP per capita
= $16,640
Child mortality
rate = 1.3%
Access to
modern sanitation
facilities = 85%
Educational attainment =30%
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A PICTURE IS WORTH A THOUSAND STATISTICS
A typical family with all their possessions in Mali, a poor country
GDP per capita
= $1,510
Child mortality
rate = 11.5%
Access to
modern sanitation
facilities = 25%
Educational attainment =7%
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INCOMES AND GROWTH AROUND THE WORLD
FACT 1: Great differences in living standards around the world.
FACT 2: Great variation in growth rates across countries.
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ECONOMIC GROWTH AROUND THE WORLD
Because of differences in growth rates
 Ranking of countries by income changes substantially
over time
 Poor countries are not necessarily doomed to poverty
forever, e.g. Singapore incomes were low in 1960 and
are quite high now
 Rich countries can’t take their status for granted: They
may be overtaken by poorer but faster-growing
countries
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ECONOMIC GROWTH AROUND THE WORLD
Questions:
 Why are some countries richer than others?
 Why do some countries grow quickly while others
seem stuck in a poverty trap?
 What policies may help raise growth rates and longrun
living standards?
PRODUCTIVITY
A country’s standard of living depends on its ability to
produce goods and services
Productivity
 Quantity of goods and services
 Produced from each unit of labor input
 Productivity = Y/L (output per worker),
where
 Y = real GDP = quantity of output produced
 L = quantity of labor
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PRODUCTIVITY
Why productivity is so important
 Key determinant of living standards
➢ When a nation’s workers are very productive,
real GDP is large and incomes are high
 Growth in productivity is the key determinant of
growth in living standards
➢ When productivity grows rapidly, so do living
standards
 An economy’s income is the economy’s output
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DETERMINANTS OF PRODUCTIVITY
Physical capital, K - stock of equipment and structures
used to produce goods and services
Physical capital per worker, K/L
 Productivity is higher when the average worker has
more capital (machines, equipment, etc.).
➢ An increase in K/L causes an increase in Y/L
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DETERMINANTS OF PRODUCTIVITY
Human capital, H - knowledge and skills workers
acquire through education, training, and experience
Human capital per worker, H/L
 Productivity is higher when the average worker has
more human capital (education, skills, etc.).
➢ An increase in H/L causes an increase in Y/L.
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DETERMINANTS OF PRODUCTIVITY
Natural resources, N - inputs into production that nature
provides (land, rivers, and mineral deposits)
Natural resources per worker, N/L
 Other things equal, more N allows a country to
produce more Y
➢ An increase in N/L causes an increase in Y/L
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DETERMINANTS OF PRODUCTIVITY
Technological knowledge
 Society’s understanding of the best ways to produce
goods and services
 Technological progress means:
➢ A faster computer, a higher-definition TV, or a
smaller cell phone
➢ Also, any advance in knowledge that boosts
productivity: allows society to get more output
from its resources
➢ e.g., Henry Ford and the assembly line.
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DETERMINANTS OF PRODUCTIVITY
Technological knowledge vs. Human capital
Technological knowledge
 Refers to society’s understanding of how to produce
goods and services
Human capital
 Results from the effort people expend to acquire
this knowledge
Both are important for productivity
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THE PRODUCTION FUNCTION
The production function Y = A ∙ F(L, K, H, N)
 A graph or equation showing the relation between
output and inputs
 F( ) is a function that shows how inputs are combined to
produce output
 “A” is the level of technology
 “A” multiplies the function F( ), so improvements in
technology (increases in “A”) allow more output (Y) to
be produced from any given combination of inputs.
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THE PRODUCTION FUNCTION
The production function has the property constant returns to
scale:
 Changing all inputs by the same percentage causes
output to change by that percentage.
 Doubling all inputs (multiplying each by 2) causes
output to double:
2Y = A∙ F(2L, 2K, 2H, 2N)
 Increasing all inputs 10% (multiplying each by 1.1)
causes output to increase by 10%:
1.1Y = A F(1.1L, 1.1K, 1.1H, 1.1N)
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THE PRODUCTION FUNCTION
If we multiply each input by 1/L, then output is
multiplied by 1/L:
Y/L = A F(1, K/L, H/L, N/L)
This equation shows that productivity (Y/L, output per
worker) depends on:
 The level of technology, A
 Physical capital per worker, K/L
 Human capital per worker, H/L
 Natural resources per worker, N,L
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ACTIVE LEARNING 1 DISCUSSION QUESTION
Which of the following policies do you think would
be most effective at boosting growth and living
standards in a poor country over the long run?
a. Offer tax incentives for investment by local firms
b. Offer tax incentives for investment by foreign firms
c. Give cash payments for good school attendance
d. Crack down on government corruption
e. Restrict imports to protect domestic industries
f. Allow free trade
ECONOMIC GROWTH AND PUBLIC POLICY
The ways public policy can affect long-run growth in
productivity and living standards:
 Saving and investment
 Diminishing returns and the catch-up effect
 Investment from abroad
 Education
 Health and nutrition
 Property rights and political stability
 Free trade
 Research and development
 Population growth
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SAVING AND INVESTMENT
Raise future productivity
 Invest more current resources in the production of
capital, K
 Trade-off: since resources are scarce, producing more
capital requires producing fewer consumption goods
 Reducing consumption = increasing saving
➢ This extra saving funds the production of investment
goods.
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DIMINISHING RETURNS
Policies that raise saving and investment
 Fewer resources are used to make consumption goods
 More resources: to make capital goods
 K increases, rising productivity and living standards
 This faster growth is temporary, due to diminishing returns
to capital: As K rises, the extra output from an additional
unit of K falls….
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Output per worker
(productivity)
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THE PRODUCTION FUNCTION & DIMINISHING
RETURNS
K/L
Y/L
Capital per worker
If workers
have little K,
giving them more
increases their
productivity a lot.
If workers already
have a lot of K,
giving them more
increases
productivity
fairly little.
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THE CATCH-UP EFFECT: THE PROPERTY WHEREBY POOR COUNTRIES
TEND TO GROW MORE RAPIDLY THAN RICH ONES
K/L
Y/L
Poor country
starts here Rich country starts here
Poor country’s
growth
Rich country’s
growth
EXAMPLE OF THE CATCH-UP EFFECT
1960–1990
 The U.S. and S. Korea devoted a similar share of GDP
to investment
➢ Expect: similar growth performance
 But growth was >6% in Korea and only 2% in the U.S.
 Explanation: the catch-up effect
➢ In 1960, K/L was far smaller in Korea than
in the U.S., hence Korea grew faster
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INVESTMENT FROM ABROAD
Investment from abroad
 Another way for a country to invest in new capital
 Foreign direct investment
➢ Capital investment that is owned and operated
by a foreign entity
 Foreign portfolio investment
➢ Investment financed with foreign money but
operated by domestic residents
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INVESTMENT FROM ABROAD
Benefits from investment from abroad
 Some benefits flow back to the foreign capital
owners
 Increase the economy’s stock of capital
 Higher productivity and higher wages
 State-of-the-art technologies developed in other
countries
 Especially good for poor countries that cannot
generate enough saving to fund investment projects
themselves
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EDUCATION
Education, investment in human capital
 Gap between wages of educated and uneducated
workers
➢ In the U.S., each year of schooling raises a
worker’s wage by 10%
 Opportunity cost: wages forgone
➢ Spending a year in school requires sacrificing
a year’s wages now to have higher wages later
Problem for poor countries: Brain drain
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HEALTH AND NUTRITION
Health care expenditure
 Is a type of investment in human capital: healthier
workers are more productive
In countries with significant malnourishment, raising
workers’ caloric intake raises productivity:
 1962–1995, caloric consumption rose 44% in S. Korea,
and economic growth was spectacular.
 Nobel winner Robert Fogel: 30% of Great Britain’s
growth from 1790–1980 was due to improved nutrition
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HEALTH AND NUTRITION
Vicious circle in poor countries
 Poor countries are poor because their populations
are not healthy
 Populations are not healthy because they are poor
and cannot afford better healthcare and nutrition
Virtuous circle
 Policies that lead to more rapid economic growth
would naturally improve health outcomes, which in
turn would further promote economic growth
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PROPERTY RIGHTS AND POLITICAL STABILITY
Markets are usually a good way to organize economic
activity
To foster economic growth
 Protect property rights (the ability of people to
exercise authority over the resources they own)
➢ Courts – enforce property rights
 Promote political stability
Property rights:
 Prerequisite for the price system to work
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PROPERTY RIGHTS AND POLITICAL STABILITY
Lack of property rights, a major problem
 Contracts are hard to enforce
 Fraud, corruption often goes unpunished
➢ Firms must bribe government officials for permits
Political instability (e.g., frequent coups)
 Creates uncertainty over whether property rights will
be protected in the future
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© 2018 CENGAGELEARNING®.MAY NOT BE SCANNED,COPIED OR DUPLICATED,OR POSTED TO A PUBLICLY
ACCESSIBLEWEBSITE,IN WHOLE OR IN PART,EXCEPT FOR USE AS PERMITTED IN A LICENSEDISTRIBUTEDWITH A
CERTAINPRODUCT OR SERVICE OR OTHERWISEON A PASSWORD-PROTECTEDWEBSITEOR SCHOOL-APPROVED
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PROPERTY RIGHTS AND POLITICAL STABILITY
When people fear their capital may be stolen by
criminals/confiscated by a corrupt government
 Less investment, including from abroad, and the
economy functions less efficiently
 Result: lower living standards
Economic stability, efficiency, and healthy growth
 Require law enforcement, effective courts, a stable
constitution, honest government officials
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FREE TRADE
Trade can make everyone better off
Inward-oriented policies
 i.e. tariffs, limits on investment from abroad
 Aim to raise living standards by avoiding interaction
with other countries
Outward-oriented policies
 i.e. elimination of restrictions on trade or foreign
investment
 Promote integration with the world economy
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FREE TRADE
Trade has similar effects as discovering new technologies
 Improves productivity and living standards
Countries with inward-oriented policies
 Have generally failed to create growth.
➢ e.g., Argentina during the 20th century.
Countries with outward-oriented policies
 Have often succeeded
➢ e.g., South Korea, Singapore, Taiwan after 1960
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RESEARCH AND DEVELOPMENT
Technological progress
 Main reason why living standards rise over the long run
Knowledge is a public good
 Ideas can be shared freely, increasing the productivity
of many
Policies to promote technological progress:
 Patent laws; Tax incentives or direct support for
private sector R&D
 Grants for basic research at universities
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ASK THE EXPERTS
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Innovation and Growth
“Future innovations worldwide will not be
transformational enough to promote sustained
per-capita economic growth rates in the United
States and western Europe over the next century
as high as those over the past 150 years.”
POPULATION GROWTH
Large population
 More workers to produce goods and services: larger
total output of goods and services
 More consumers
Population growth may affect living standards in 3
different ways…
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POPULATION GROWTH
1. Stretching natural resources
 200 years ago, Malthus argued that population
growth will:
➢ Strain society’s ability to provide for itself
➢ Mankind - doomed to forever live in poverty
 Since then, the world population has increased sixfold
and living standards increased
➢ Malthus failed to account for technological
progress and productivity growth
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2. Diluting the capital stock
 High population growth (higher L)
 Spread the capital stock more thinly (lower K/L)
 Lower productivity and living standards
To combat this, many developing countries use policy to
control population growth
 Government regulation (China’s one child law)
 Increased awareness of birth control
 Equal opportunities for women (Promote female literacy
to raise opportunity cost of having babies)
POPULATION GROWTH
3. Promoting technological progress
 World population growth
➢ Engine for technological progress and economic
prosperity
➢ More people = More scientists, more inventors, more
engineers = More frequent discoveries
Michael Kremer, human history:
 Growth rates increased as the world’s population
increased
 More populated regions grew faster than less populated
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ACTIVE LEARNING 2 ANSWERS
Determinants of productivity:
 K/L, physical capital per worker
 H/L, human capital per worker
 N/L, natural resources per worker
 A, technological knowledge
Policies to boost productivity:
 Encourage saving and investment, to raise K/L
 Encourage investment from abroad, to raise K/L
 Provide public education, to raise H/L
 Patent laws or grants, to increase A
 Control population growth, to increase K/L
ARE NATURAL RESOURCES A LIMIT TO
GROWTH?
Some argue that population growth
 Is depleting the Earth’s non-renewable resources
 And thus will limit growth in living standards.
But technological progress often yields ways to avoid
these limits:
 Hybrid cars use less gas.
 Better insulation in homes reduces the energy
required to heat or cool them.
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ARE NATURAL RESOURCES A LIMIT TO
GROWTH?
Market economy, scarcity is reflected in market prices
 If the world were running out of natural resources,
their prices would be rising over time
 In real terms, the prices of most natural resources are
stable or falling
 It appears that our ability to conserve these resources
is growing more rapidly than their supplies are
dwindling
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CONCLUSION
In the long run
 Living standards are determined by productivity
Policies that affect the determinants of productivity
 Will therefore affect the next generation’s living standards
One of these determinants: saving & investment
 Next chapter: how saving and investment are determined,
and how policies can affect them
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SUMMARY
• There are great differences across countries in living
standards and growth rates.
• Productivity (output per unit of labor) is the main
determinant of living standards in the long run.
• Productivity depends on physical and human capital
per worker, natural resources per worker, and
technological knowledge.
• Growth in these factors - especially technological
progress - causes growth in living standards over the
long run.
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SUMMARY
• Policies can affect the following, each of which has
important effects on growth:
➢ Saving and investment; International trade
➢ Education, health & nutrition
➢ Property rights and political stability
➢ Research and development
➢ Population growth
• Because of diminishing returns to capital, growth from
investment eventually slows down, and poor countries
may “catch up” to rich ones.
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