Long Run Economic Growth

Nature of Economic Growth

Economic growth refers to the sustained, long-run increase in the level of real Gross Domestic Product (GDP) of an economy. It is a central focus of macroeconomics because it determines improvements in living standards over time.

• Real GDP: The total value of all goods and services produced in an economy, adjusted for inflation.

• Real per capita GDP: Real GDP divided by the population, indicating average income per person.

• Real GDP per employed worker: A measure of productivity per worker.

Example: A graph typically shows that real GDP, real per capita GDP, and real GDP per worker all rise over time, but at different rates.

Cumulative Effect of Economic Growth

Small differences in annual growth rates can lead to large differences in income levels over time. The following table illustrates how $100 grows over 100 years at different annual growth rates:

Key Point: Even a 1% difference in growth rate can lead to vastly different outcomes over a century.

The Rule of 72

The "rule of 72" is a simple way to estimate how long it takes for a variable to double, given a constant annual growth rate.

• Doubling time (in years) ≈ 72 / (annual growth rate in percent)

Example: If GDP grows at 3% per year, it will double in years.

Benefits and Costs of Economic Growth

Raising Average Living Standards

Economic growth is a powerful means of improving average material living standards. As average income rises, consumption patterns shift from tangible goods to services, and higher incomes often lead to greater demand for a cleaner environment.

• Material living standards improve as people can afford more goods and services.

• Societal consumption patterns evolve with income growth.

• Environmental quality often becomes a higher priority as societies grow wealthier.

Addressing Poverty and Income Inequality

While economic growth can raise average incomes, it does not always benefit all groups equally. In many countries, recent income growth has been concentrated among top earners, leading to increased income inequality.

• Poverty and income inequality remain significant policy challenges even as average incomes rise.

• Public policy must address the distributional effects of growth.

Example: Data shows the top 1% income share rising in several countries over recent decades.

Costs of Economic Growth

• Forgone Consumption: Achieving higher future output often requires reducing current consumption to allow for more investment.

• Social Costs: Economic growth can be disruptive, causing some workers' skills to become obsolete and leading to structural unemployment.

Opportunity Cost: The opportunity cost of economic growth is the current consumption that is sacrificed to enable higher future consumption.

Opportunity Cost of Forgone Consumption

A typical diagram shows that reduced current consumption (the opportunity cost) is offset by higher future consumption (the benefit of growth). The time it takes for the benefits to outweigh the costs is sometimes called the "break-even" point.

Determinants of Economic Growth

Major Determinants

There are four major determinants of long-run economic growth:

1. Growth in the labour force: Increases in the number of workers can raise total output.

2. Growth in human capital: Improvements in education, skills, and health of workers enhance productivity.

3. Growth in physical capital: Investment in machinery, infrastructure, and technology increases productive capacity.

4. Technological improvement: Innovations and advances in knowledge drive productivity growth.

Different growth theories emphasize different sources among these determinants.

Investment, Saving, and Growth

Basic Macroeconomic Relationships

In the short-run macroeconomic model, equilibrium real GDP () is determined by the sum of desired consumption () and desired investment ():

• Rearranged: or (where is saving)

In the long run, real GDP is at its potential level (), and the interest rate adjusts to ensure that saving equals investment.

Government, Saving, and Growth

When including the government sector:

• Private saving: (where is net taxes)

• Public saving: (where is government purchases)

• National saving:

Increases in household consumption or government purchases reduce national saving, which in turn affects investment and growth.

Market for Financial Capital

The supply of national saving and the demand for investment determine the equilibrium real interest rate in the financial capital market.

• Excess supply of saving lowers the real interest rate.

• Excess demand for investment raises the real interest rate.

Changes in saving or investment shift the equilibrium, affecting the growth rate of potential output.

Investment, Saving, and Globalized Financial Markets

In a closed economy, changes in national saving or investment affect the domestic interest rate. In an open economy, financial capital is mobile internationally, and interest rates tend to move together across countries due to the law of one price.

• Excess supply of financial capital leads to capital outflows (investment abroad).

• Excess demand leads to capital inflows (borrowing from abroad).

Theories of Economic Growth

The Neoclassical Growth Model

The neoclassical model uses an aggregate production function to describe how output is produced from inputs:

• = labour, = physical capital, = human capital, = technology

Key properties:

• Diminishing marginal returns: Increasing one input while holding others constant yields smaller and smaller increases in output.

• Constant returns to scale: Increasing all inputs by the same proportion increases output by that proportion.

For simplicity, human and physical capital are often combined, and technology is held constant in basic models.

Growth in the Neoclassical Model

• Labour-force growth: With fixed capital, more workers increase GDP, but per capita output may fall due to diminishing returns.

• Capital accumulation: Increases in capital improve living standards, but each additional unit of capital adds less to output.

• Balanced growth: If capital and labour grow at the same rate, total output rises, but per capita output does not necessarily improve unless technology advances.

• Technological change: Considered exogenous in the neoclassical model, technological progress is necessary for sustained increases in per capita output.

Solow Residual and Growth Accounting

Robert Solow developed a method to estimate the contribution of technological change to economic growth, known as the "Solow residual." It measures the portion of growth not explained by increases in capital or labour.

• Solow residual: The unexplained part of output growth, attributed to technological progress.

• Limitation: If new capital embodies new technology, the method may underestimate true technological change.

Endogenous Growth Theory

Modern theories argue that technological change is endogenous—driven by economic incentives and activities such as innovation, learning by doing, and knowledge transfer.

• Growth results from purposeful, innovative activity in response to market signals.

• Institutions and market structure play key roles in fostering innovation.

Ideas as a Source of Increasing Returns

Ideas differ from physical capital because they are non-rivalrous (can be used by many without being depleted) and often only partially excludable (difficult to prevent others from using them). As a result, ideas generate spillovers that can make long-run growth self-reinforcing.

• Public good: Ideas can benefit many people simultaneously.

• Spillovers from ideas can sustain long-run economic growth.

Limits to Growth and Sustainability

Resource Exhaustion

Rapid economic growth has increased the consumption of natural resources. However, most economists argue that absolute limits to growth are not relevant because technology and resource stocks change over time.

• Technological advances can increase resource efficiency and create substitutes.

• What seems impossible today may become feasible in the future due to innovation.

Environmental Degradation and Climate Change

As the global population and economic activity have grown, managing pollution and greenhouse gas emissions has become a critical challenge. Sustainable growth requires collective, long-term action and a focus on knowledge-driven technological change.

• Growth can help address global problems, but must be sustainable.

• Environmental management is essential for long-term prosperity.

Summary Table: Key Determinants and Effects of Economic Growth

Additional info: These notes synthesize and expand upon the provided lecture slides, adding definitions, examples, and context for clarity and completeness.