Long-Run Economic Growth

Definition and Importance

Long-run economic growth refers to the sustained increase in a nation's output of goods and services over time, typically measured by rising productivity and improvements in the average standard of living. This concept is distinct from short-run economic fluctuations, which are described by the business cycle.

• Long-run economic growth: The process by which rising productivity increases the average standard of living.

• Business cycle: Alternating periods of economic expansion and recession.

• Real GDP per capita: The amount of production in the economy per person, adjusted for changes in the price level.

Example: The United States has experienced a nine-fold increase in real GDP per capita since 1900, reflecting significant improvements in living standards.

Economic Prosperity and Health

Economic prosperity and health are closely linked. Wealthier nations can allocate more resources to healthcare, resulting in higher life expectancy and healthier, more productive citizens.

• Growth in real GDP per capita is associated with improvements in health and lifespan.

• Life expectancy has increased significantly in developed countries over the last century.

Calculating Growth Rates

Growth rates measure the percentage change in an economic variable, such as real GDP, from one period to the next. Over several years, average growth rates can be calculated to estimate the annual rate of growth.

• Growth rate formula:

• Average annual growth rate:

Example: If real GDP was \frac{21.8 - 21.4}{21.4} \times 100 = 1.9\%$

Growth Rates over Longer Periods

For longer time periods, the average growth rate can be found by solving for the rate that links the initial and final values of real GDP.

• General formula:

• Rule of 70: Estimates the number of years required for a variable to double at a constant growth rate.

Example: At a 5% growth rate, a variable will double in years.

Determinants of Long-Run Growth

Increases in real GDP per capita depend on increases in labor productivity, which is the amount of goods and services produced by one worker or one hour of work.

• Labor productivity: Key driver of long-run economic growth.

• Higher productivity allows for greater consumption and higher living standards.

Factors Affecting Labor Productivity Growth

Several factors contribute to growth in labor productivity:

• Increases in capital per hour worked: Capital includes physical assets (machinery, buildings) and intellectual property.

• Human capital: The accumulated knowledge and skills workers possess.

• Technological change: Improvements in capital or methods to combine inputs into outputs (e.g., new technologies).

• Role of entrepreneurs: Entrepreneurs drive innovation and economic growth.

• Property rights: Secure property rights and contract enforcement encourage investment and growth.

Example: Governments can promote growth by establishing independent courts to enforce contracts.

Saving, Investment, and the Financial System

Services Provided by the Financial System

The financial system facilitates economic growth by providing key services:

• Risk sharing: Allows savers and borrowers to share financial risks.

• Liquidity: Enables assets to be easily converted to cash.

• Information: Provides information to savers and borrowers about investment opportunities.

Macroeconomics of Savings and Investment

In a closed economy (no exports or imports), the total value of saving equals the total value of investment.

• GDP identity:

• Closed economy:

• Investment:

Savings

Savings are divided into private savings (by households) and public savings (by the government).

• Private savings:

• Public savings:

• Total savings:

Example: If the government spends as much as it collects in taxes, public savings is zero (balanced budget).

Savings Equals Investment

In a closed economy, total savings must equal investment:

• Budget deficits (negative public savings) reduce funds available for investment.

• Budget surpluses (positive public savings) increase funds available for investment.

The Market for Loanable Funds

The market for loanable funds models the interaction between borrowers and lenders, determining the market interest rate and the quantity of funds exchanged.

• Households supply loanable funds; firms demand them for investment.

• Government borrowing (dissaving) affects the supply of funds available to firms.

Effects of Changes in the Loanable Funds Market

Various factors can shift the demand or supply for loanable funds, affecting interest rates and investment.

• Increase in demand: Technological change makes investments more profitable, increasing demand for loanable funds, raising the real interest rate and quantity loaned.

• Budget deficit: Government borrowing reduces supply of funds to firms, raises the real interest rate, and decreases investment (crowding out).

Additional info: Crowding out refers to the decline in private investment due to increased government borrowing.

Importance of Crowding Out

In practice, the effect of government budget deficits on interest rates is relatively small, as global financial markets influence domestic interest rates.

• Example: A 1% increase in government borrowing as a share of GDP may raise the real interest rate by only 0.03 points.

The Business Cycle

Definition and Phases

The business cycle refers to the alternating periods of economic expansion and contraction experienced by an economy.

• Expansion: Periods when real GDP is rising.

• Recession: Periods when real GDP is falling.

Example: The U.S. economy has experienced multiple recessions and expansions since the early 19th century.

Phases of the Business Cycle

• Near the end of an expansion: Interest rates and wages rise faster than other prices; firm profits fall.

• As a recession begins: Firms decrease investment, households consume less, and employment declines.

• Recovery: Firms and households increase investment and consumption, leading to rising employment.

Effect of the Business Cycle on Inflation

The inflation rate measures the change in the price level from one year to the next.

• During expansions: High demand leads to higher inflation.

• During recessions: Low demand leads to lower inflation or deflation.

Return to Stability: The Great Moderation

Several factors have contributed to the increased stability of the U.S. economy, known as the Great Moderation.

• Increasing importance of services: Services are less affected by recessions than manufacturing.

• Establishment of unemployment insurance and government transfer programs: These help maintain consumer spending during recessions.

• Federal government stabilization policies: Policies aimed at lengthening expansions and minimizing recessions.

• Stability of the financial system: A stable financial system is crucial for macroeconomic stability.

Additional info: The debate over the role of government in stabilizing the economy intensified during the 2007-2009 recession.