Economic Growth

Key Concepts & Definitions

Economic growth is a central topic in macroeconomics, focusing on the increase in a country's output and living standards over time. Understanding the sources and measurement of growth is essential for analyzing long-term prosperity and policy effectiveness.

• Economic Growth: The increase in GDP per capita of an economy over time.

• Catch-up Growth: Rapid growth in poorer countries as they adopt existing technologies from richer nations; not guaranteed for all countries.

• Sustained Growth: Positive, relatively steady growth over long periods (e.g., 50–200+ years, as seen in the UK, USA, France).

• Physical Capital (K): Machines, buildings, and equipment used in production.

• Human Capital (H): The workforce's skills, education, and experience, measured as efficiency units of labor.

• Technology (A): The level of knowledge and innovation used to convert inputs into output.

• Depreciation Rate (d): The fraction of the capital stock that wears out each period.

• Savings Rate (s): The fraction of income that households save rather than consume.

• Steady-State Equilibrium: The point where investment equals depreciation, so the capital stock remains constant.

• Aggregate Investment (I): Total investment in the economy, equal to aggregate saving in a closed economy.

Key Formulas

• Compound Growth Formula:

• Capital Accumulation Equation:

• Investment & Savings Identity: where

• Steady-State Condition (Investment = Depreciation):

• Fisher Equation (Real Interest Rate):

The Solow Growth Model — Critical Logic

• The Solow diagram plots the production function and the investment function against capital stock .

• The depreciation line is linear and passes through the origin.

• Steady state (): Where the investment curve crosses the depreciation line.

• If : Investment > Depreciation → grows toward .

• If : Depreciation > Investment → shrinks toward .

• Higher savings rate () shifts the investment curve up and right, resulting in higher and .

Growth, Inequality & Poverty

• Economic growth can reduce poverty, but only if not accompanied by a large rise in inequality.

• Growth does not always reduce inequality; it depends on the distribution of gains.

• Growth does not always reduce poverty if inequality rises sharply.

Fundamental Causes of Prosperity

Key Concepts & Definitions

Understanding why some countries are rich and others are poor involves distinguishing between proximate and fundamental causes of prosperity.

• Proximate Causes: Physical capital, human capital, and technology—direct inputs explaining high GDP per capita.

• Fundamental Causes: Deeper reasons for differences in proximate factors: geography, culture, and institutions.

• Geography Hypothesis: Suggests that tropical climates and disease environments reduce productivity and cause poverty.

• Culture Hypothesis: Argues that cultural values (work ethic, savings, openness to innovation) drive prosperity differences.

• Institutions Hypothesis: Claims that rules governing society (property rights, contracts, free entry) are the main drivers of prosperity.

• Inclusive Institutions: Protect property rights, enforce contracts, allow free entry, and support impartial justice.

• Extractive Institutions: Restrict property rights, do not enforce contracts, limit entry, and remove resources from the economy.

• Creative Destruction: Economic growth can destabilize existing power structures; rulers may use extractive institutions to prevent this.

• Reversal of Fortune: Historically prosperous colonies often received extractive institutions, while poorer colonies received more inclusive ones.

The Institutions Framework — Critical Logic

• Extractive institutions reduce entrepreneurship by weakening property rights (shifting the return-to-entrepreneurship curve left) and raising barriers to entry (shifting the opportunity cost line up).

• Result: Fewer entrepreneurs, less innovation, and slower growth.

• Example: North Korea vs. South Korea

  • Same geography and culture, but different institutions after 1947.

  • South Korea: Market economy, property rights, incentives for investment → GDP ~$30,000 (2010).

  • North Korea: Communist system, no private property, banned markets → GDP ~$1,500 (2010).

  • Conclusion: Institutions, not geography or culture, explain the difference.

Labor Market

Key Concepts & Definitions

The labor market determines employment, wages, and the allocation of workers. Understanding its structure is crucial for analyzing unemployment and policy interventions.

• Labor Force: Employed plus unemployed individuals actively seeking work.

• Unemployment Rate: Percentage of the labor force that is unemployed.

• Labor Force Participation Rate (LFPR): Labor force as a percentage of the adult population.

• Value of Marginal Product of Labor (VMP_L): ; the demand curve for labor.

• Marginal Product of Labor (MP_L): Additional output from hiring one more worker; diminishes as more workers are added.

• Profit Maximization: Firms hire workers until (wage).

• Frictional Unemployment: Due to job search and imperfect information; natural and normal.

• Structural Unemployment: Due to skill mismatches between workers and available jobs.

• Cyclical Unemployment: Due to economic downturns; firms cut workers when demand falls.

• Downward Wage Rigidity: Wages are 'sticky' downward; firms prefer layoffs over wage cuts, causing unemployment.

Key Formulas & Calculations

• Unemployment Rate:

• Employment Rate:

• Labor Force:

• Labor Force Participation Rate (LFPR):

• Employment-Population Ratio:

• Underemployment Rate:

• Value of Marginal Product & Hiring Rule: Hire until:

Labor Demand & Supply — What Causes Shifts

• Labor Demand Curve Shifts:

  • Shifts right (increases) when: Output price rises, productivity improves, demand for the good increases, or other input prices fall.

  • Shifts left (decreases) when: Output price falls, productivity decreases, demand for the good decreases, or other input prices rise.

  • Change in wage causes movement along the curve, not a shift.

• Labor Supply Curve Shifts:

  • Shifts right (increases) when: Opportunity cost of working outside the home decreases, population grows, or demographics favor work.

  • Shifts left (decreases) when: Childcare costs increase, population declines, or workers leave the labor force.

  • Supply curve slopes upward: Higher wages increase quantity of labor supplied.

Downward Wage Rigidity & Unemployment

• If labor demand falls and wages cannot fall (sticky downward):

  • Wage remains at original .

  • Quantity of labor demanded falls; quantity supplied stays the same at .

  • Unemployment equals the gap between quantity supplied and quantity demanded at the rigid wage.

• If wages are flexible: Wage falls to new equilibrium, and unemployment returns to zero (market clears).

Credit Market

Key Concepts & Definitions

The credit market matches borrowers and lenders, determining interest rates and the allocation of funds in the economy. Understanding its structure is vital for analyzing financial stability and policy.

• Nominal Interest Rate: The stated interest rate before adjusting for inflation.

• Real Interest Rate: Nominal rate minus inflation rate; the true cost of borrowing or return to saving.

• Credit Demand Curve: Slopes downward; higher real interest rates reduce borrowing.

• Credit Supply Curve: Slopes upward; higher real interest rates increase saving.

• Asset: Something owned by a bank; if sold, payment goes to the bank.

• Liability: Something owed by a bank; if settled, payment comes from the bank.

• Stockholders' Equity: Assets minus liabilities; what the bank owns net of what it owes.

• Liquidity: Ease of converting an asset to cash without loss of value.

• Bank Run: Large volume of withdrawals that can make a solvent bank insolvent.

• Solvent Bank: Total assets exceed total liabilities (positive stockholders' equity).

• SIFI (Systemically Important Financial Institution): A bank or institution too large to fail without systemic consequences.

Key Formulas & Relationships

• Interest Rate Relationship (Fisher Equation):

• Bank Balance Sheet Identity:

Table: Summary of Key Labor Market and Credit Market Formulas

Example: If a bank has $100 million in assets and $90 million in liabilities, its stockholders' equity is $10 million.

Additional info: Students should review textbook chapters and homework for more detailed examples and applications, as exams may cover material beyond this guide.