Long-Run Economic Growth

Incomes and Growth Around the World

Long-run economic growth examines how living standards and incomes evolve across countries over time. There are significant differences in both living standards and growth rates globally.

• Fact 1: There are vast differences in living standards around the world.

• Fact 2: There is great variation in growth rates across countries.

Productivity

Productivity is the key determinant of a country's standard of living. It measures the average quantity of goods and services produced per unit of labor.

• Definition: Productivity = output per hour of work.

• Formula: where Y = real GDP (output produced), L = quantity of labor.

• Higher productivity leads to higher real GDP and incomes.

• Growth in productivity results in rising living standards.

Determinants of Productivity

Several factors influence productivity and its growth rate:

• Physical Capital per Worker (K/L): The stock of equipment and structures used to produce goods and services. More capital per worker increases productivity.

• Human Capital per Worker (H/L): The knowledge and skills acquired through education, training, and experience. More human capital per worker increases productivity.

• Technological Knowledge: Society's understanding of the best ways to produce goods and services. Advances in technology boost productivity.

Saving and Investing

Increasing capital (K) requires investment, which is funded by saving. There is a trade-off between current consumption and future productivity.

• Reducing consumption increases saving, which funds investment in capital goods.

• Investment from abroad (foreign direct and portfolio investment) can raise capital per worker and productivity.

Education

Investment in human capital through education increases productivity. Each year of schooling typically raises a worker's wage.

• Education involves a trade-off: sacrificing current wages for higher future earnings.

Incentives and Institutions

Institutions are the "rules of the game" that structure economic incentives and promote growth.

• Key institutions: property rights, honest government, political stability, dependable legal system.

Free Trade

Trade policies affect economic growth. Outward-oriented policies promote integration with the world economy and tend to foster growth, while inward-oriented policies often fail.

• Trade improves productivity and living standards, similar to technological progress.

Research and Development (R&D)

Technological progress is the main driver of rising living standards in the long run. Knowledge is a public good, and policies can promote R&D.

• Examples: patent laws, tax incentives, grants for university research.

The Financial System

Financial Institutions

The financial system matches the saving of one person with the investment of another. It consists of financial markets and financial intermediaries.

• Financial Markets: Savers provide funds directly to borrowers.

  • The Bond Market: Bonds are certificates of indebtedness with maturity date, yield, and principal. Bonds differ by term, credit risk, and tax treatment.

  • The Stock Market: Stocks represent partial ownership in firms. Equity finance (selling stock) and debt finance (selling bonds) are ways to raise capital. Key metrics: price, dividend, PE ratio.

• Financial Intermediaries: Savers provide funds indirectly to borrowers.

  • Examples: commercial banks, mutual funds.

  • Banks create a medium of exchange and reduce search/monitoring costs.

  • Mutual funds allow savers to diversify their investments.

Different Kinds of Saving

• Private Saving: Portion of household income not used for consumption or taxes.

• Public Saving: Tax revenue less government spending.

• Budget Surplus: Excess of tax revenue over government spending.

• Budget Deficit: Shortfall of tax revenue from government spending.

• National Saving: Sum of private and public saving.

Saving and Investment

National income accounting identity in a closed economy:

• Solve for investment:

Meaning of Saving and Investment:

• Saving: Income not spent on consumption or taxes; used to buy bonds, stocks, mutual funds, or kept in accounts.

• Investment: Purchase of new capital (factories, equipment, houses). Note: In economics, investment does not mean buying stocks or bonds.

The Market for Loanable Funds

The market for loanable funds is a supply-demand model for the financial system, explaining how saving and investment are coordinated and how interest rates are determined.

• Supply of loanable funds comes from saving (households and public saving).

• Demand for loanable funds comes from investment (firms and households).

• There is one interest rate, which is both the return to saving and the cost of borrowing.

Measuring the Cost of Living

The Consumer Price Index (CPI)

The CPI measures the typical cost of living for consumers by tracking the prices of a fixed basket of goods and services.

• Steps to calculate CPI:

  1. Fix the basket: Determine what is in the typical consumer's shopping basket.

  2. Find the prices: Collect data on prices of all goods in the basket.

  3. Compute the basket's cost: Calculate total cost using current prices.

  4. Choose a base year and compute the index:

  5. Compute the inflation rate:

Problems with the CPI

• Substitution Bias: CPI uses a fixed basket and misses consumers substituting toward cheaper goods, overstating cost increases.

• Introduction of New Goods: New goods increase variety and value, but CPI misses this effect.

• Unmeasured Quality Change: Improvements in quality increase value, but CPI may not fully account for this.

Contrasting the CPI and GDP Deflator

The CPI and GDP deflator are both measures of price level, but differ in coverage:

Additional info: The GDP deflator reflects prices of all domestically produced goods and services, while CPI focuses on consumer goods and services.

Correcting Variables for Inflation

Inflation makes it difficult to compare dollar amounts from different times. To compare, use the CPI to adjust values:

• Example: Comparing minimum wage in 1964 ($1.15) and 2024 ($7.25) using CPI.

Real vs Nominal Interest Rates

Interest rates can be measured in nominal or real terms. The real interest rate adjusts for inflation, reflecting the true increase in purchasing power.

• Nominal Interest Rate: Not corrected for inflation; rate of growth in dollar value.

• Real Interest Rate: Corrected for inflation; rate of growth in purchasing power.