PART IV Further Macroeconomics Issues PRINCIPLES OF MACROECONOMICS

PART IV Further Macroeconomics Issues PRINCIPLES OF MACROECONOMICS ELEVENTH EDITION CASE FAIR OSTER PEARSON © 2012 Pearson Education, Inc. Publishing as Prentice Hall Prepared by: Fernando Quijano w/Shellyof. Tefft 20

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Long-Run Growth 17 CHAPTER OUTLINE The Growth Process: From Agriculture to Industry Sources of Economic Growth Increase in Labor Supply Increase in Physical Capital Increase in the Quality of the Labor Supply (Human Capital) Increase in the Quality of Capital (Embodied Technical Change) Disembodied Technical Change More on Technical Change U. S. Labor Productivity: 1952 I– 2010 I Growth and the Environment and Issues of Sustainability © 2014 Pearson Education, Inc. 3 of 25

output growth The growth rate of the output of the entire economy. per-capita output growth The growth rate of output person in the economy. labor productivity growth The growth rate of output per worker. © 2014 Pearson Education, Inc. 4 of 25

The Growth Process: From Agriculture to Industry FIGURE 17. 1 Economic Growth Shifts Society’s Production Possibility Frontier Up and To the Right The production possibility frontier shows all the combinations of output that can be produced if all society’s scarce resources are fully and efficiently employed. Economic growth expands society’s production possibilities, shifting the ppf up and to the right. © 2014 Pearson Education, Inc. 5 of 25

Beginning in England around 1750, technical change and capital accumulation increased productivity significantly in two important industries: agriculture and textiles. New inventions and new machinery meant that more could be produced with fewer resources. Growth meant new products, more output, and wider choice. A rural agrarian society was quickly transformed into an urban industrial society. Economic growth continues today in the developed world, and while the underlying process is still the same, the face is different. Growth comes from a bigger workforce and more productive workers. Higher productivity comes from tools (physical capital); a better-educated and more highly skilled workforce (human capital); and increasingly from innovation, technical change, and newly developed products and services. © 2014 Pearson Education, Inc. 6 of 25

TABLE 17. 1 Growth of Real GDP: 1991– 2007 Country Average Growth Rates per Year, Percentage Points, 1993 -2012 United States 2. 5 Japan 0. 8 Germany 1. 2 France 1. 5 United Kingdom 2. 1 China 10. 1 India 6. 9 Sub-Saharan Africa 4. 6 catch-up The theory stating that the growth rates of less developed countries will exceed the growth rates of developed countries, allowing the less developed countries to catch up. The idea that gaps in national incomes tend to close over time is called convergence theory. An economic historian coined the term the advantages of backwardness over 50 years ago to describe the phenomenon of less developed countries leaping ahead by borrowing technology from more developed countries. © 2014 Pearson Education, Inc. 7 of 25

Sources of Economic Growth aggregate production function A mathematical relationship stating that total GDP (output) depends on the total amount of labor used and the total amount of capital used. The numbers that are used in Tables 17. 2 and 17. 4 that follow are based on the simple production function Y = 3 × K 1/3 L 2/3. Both capital and labor are needed for production and increases in either result in more output. Using this construct we can now explore exactly how an economy achieves higher output levels over time as it experiences changes in labor and capital. © 2014 Pearson Education, Inc. 8 of 25

ECONOMICS IN PRACTICE Government Strategy for Growth Consider how far an individual country is from the technological frontier of the rest of the world. The distance from that frontier might influence growth strategies pursued by that country. Suppose a country is behind relative to the world at large. A government’s job here is helping its industries to catch up. The government knows what the right technology is and can help its firms find the world frontier. As firms develop and approach the world technological frontier, growth will come from innovation. For this reason, policies to support entrepreneurship and improve the workings of venture capital will likely work better. Acemoglu and his colleagues argue that governments often shift too late from policies supporting adoption of other countries’ ideas to supporting their own innovative efforts. THINKING PRACTICALLY 1. In recent years China has begun to strengthen its laws on patents. How does this fit in with the research described here? © 2014 Pearson Education, Inc. 9 of 25

Increase in Labor Supply In the absence of increases in the capital stock, as labor increases, less and less output will be added by each new worker. This effect is called diminishing returns. With diminishing returns, as labor supply grows, output increases, but at a declining rate, and increases in the labor supply reduce labor productivity, or output per worker. TABLE 17. 2 Economic Growth from an Increase in Labor—More Output but Diminishing Returns and Lower Labor Productivity Period Quantity of Labor L Quantity of Capital K Total Output Y Labor Productivity Y/L Marginal Return to Labor ΔY/ΔL 1 100 300 3. 0 2 110 100 320 2. 9 2. 0 3 120 100 339 2. 8 1. 9 4 130 100 357 2. 7 1. 8 © 2014 Pearson Education, Inc. 10 of 25

TABLE 17. 3 Employment, Labor Force, and Population Growth, 1960– 2011 Civilian Noninstitutional Population 16 and Over (Millions) 1960 1970 1980 1990 2000 2011 Percentage change, 1960– 2011 Percentage change at annual rate 117. 3 137. 1 167. 7 189. 2 212. 6 239. 6 +104. 3% +1. 4% Civilian Labor Force Number Percentage Employment (Millions) of Population (Millions) 69. 6 82. 8 106. 9 125. 8 142. 6 153. 6 +120. 7% +1. 6% 59. 3 60. 4 63. 7 66. 5 67. 1 64. 1 65. 8 78. 7 99. 3 118. 8 136. 9 139. 9 +112. 6% +1. 6% Between 1960 and 2011, the population 16 and over grew at an annual rate of 1. 4 percent, the labor force grew at an annual rate of 1. 6 percent, and employment grew at an annual rate of 1. 6 percent. © 2014 Pearson Education, Inc. 11 of 25

Increase in Physical Capital There are likewise diminishing returns to capital when more and more capital is added to a fixed supply of labor. TABLE 17. 4 Economic Growth from an Increase in Capital—More Output, Diminishing Returns to Added Capital, Higher Labor Productivity Period Quantity of Labor L Quantity of Capital K Total Output Y Labor Productivity Y/L Output per Capital Y/K Marginal Return to Capital ΔY/ΔK 1 100 300 3. 0 2 100 110 3. 1 2. 8 1. 0 3 100 120 319 3. 2 2. 7 0. 9 4 100 130 327 3. 3 2. 5 0. 8 Observe two things about these numbers. First, additional capital increases labor productivity—it rises from 3. 0 to 3. 3 as capital is added. Second, there are diminishing returns to capital. The last column in the table shows the decline in output per capital as capital is increased. © 2014 Pearson Education, Inc. 12 of 25

TABLE 17. 5 Fixed Private Nonresidential Net Capital Stock, 1960– 2011 (Billions of 2005 Dollars) Equipment Structures 1960 670. 9 3, 001. 4 1970 1, 154. 0 4, 149. 2 1980 1, 931. 6 5, 480. 4 1990 2, 620. 0 7, 257. 7 2000 4, 230. 8 8, 570. 7 2011 5, 509. 6 9, 878. 6 Percentage change, 1960– 2011 +721. 2% +229. 1% +4. 2% + 2. 4% Percentage change at an annual rate Between 1960 and 2011 the stock of equipment grew at an annual rate of 4. 2 percent and the stock of structures grew at an annual rate of 2. 4 percent. Notice that the growth rates of capital are larger than the growth rates of labor in the previous table. So, capital has grown relative to labor. © 2014 Pearson Education, Inc. 13 of 25

New capital can come from the saving of a country’s residents and/or from the investments of foreigners. foreign direct investment (FDI) Investment in enterprises made in a country by residents outside that country. Countries with poor institutions, corruption, and inadequate protection for lenders and investors struggle to attract capital. The World Bank calls countries with weak institutions fragile countries. © 2014 Pearson Education, Inc. 14 of 25

Increase in the Quality of the Labor Supply (Human Capital) TABLE 17. 6 Years of School Completed by People Over 25 Years Old, 1940– 2010 1940 1950 1960 1970 1980 1990 2000 2010 Percentage with Less than 5 Years of School Percentage with 4 Years of High School or More Percentage with 4 Years of College or More 13. 7 11. 1 8. 3 5. 5 3. 6 NA NA NA 24. 5 34. 3 41. 1 52. 3 66. 5 77. 6 84. 1 87. 1 4. 6 6. 2 7. 7 10. 7 16. 2 21. 3 25. 6 29. 9 NA = not available. The level of educational attainment in the United States has risen significantly since 1940. As the quality of labor increases through more education, labor productivity increases. Policy makers in many developed economies are concerned about their ability to continue to generate growth through human capital improvements. © 2014 Pearson Education, Inc. 15 of 25

ECONOMICS IN PRACTICE German Jewish Émigrés Contribute to U. S. Growth By the time World War II began, over 133, 000 Jewish émigrés found their way to the United States. Among them were several thousand academics, Among the émigrés were a number of chemists. The chemists brought with them their considerable human capital. Moser and her colleagues then compared the rate of patenting in the United States in the period before the emigration with the one right after, looking specifically at the fields within chemistry in which the new émigrés worked. Their results? The work indicates that these new U. S. citizens may have increased patent rates in their fields by more than 30%! THINKING PRACTICALLY 1. Show on a production possibility frontier the effects of the new German emigration. © 2014 Pearson Education, Inc. 16 of 25

Increase in the Quality of Capital (Embodied Technical Change) embodied technical change Technical change that results in an improvement in the quality of capital. An increase in the quality of capital increases labor productivity (more output for the same amount of labor). We thus have our third answer as to why labor productivity has increased over time—the quality of capital has increased because of embodied technical change. Disembodied Technical Change disembodied technical change Technical change that results in a change in the production process. To the extent that disembodied technical changes are mostly positive, this is our fourth answer as to why labor productivity has increased. People have figured out how to run production processes and how to manage firms more efficiently. © 2014 Pearson Education, Inc. 17 of 25

More on Technical Change The main point to keep in mind is that technical change, regardless of how it is categorized, increases labor productivity. invention An advance in knowledge. innovation The use of new knowledge to produce a new product or to produce an existing product more efficiently. A commonly used measure of inputs into research is the fraction of GDP spent. The United States will lose some of its edge in technology unless more funding is provided. In 2007, the National Academies of Science argued as follows: Although many people assume that the United States will always be a world leader in science and technology, this may not continue to be the case inasmuch as great minds and ideas exist throughout the world. We fear the abruptness with which a lead in science and technology can be lost—and the difficulty of recovering a lead once lost, if indeed it can be recovered at all. © 2014 Pearson Education, Inc. 18 of 25

U. S. Labor Productivity: 1952 I– 2012 IV FIGURE 17. 2 Output per Worker Hour (Productivity), 1952 I– 2012 IV There was a slowdown in productivity growth in the 1970 s. Some of the explanations for this slow down included a low rate of saving, environmental and government regulation, and little spending on R&D. Many of these factors turned around in the 1980 s and 1990 s and productivity rose to 1. 9% in the 1990 s through 2012. © 2014 Pearson Education, Inc. 19 of 25

Growth and the Environment and Issues of Sustainability TABLE 17. 7 Environmental Scores in the World Bank Country Policy and Institutional Assessment 2005 Scores (min = 1, max = 6) Albania 3 Angola 2. 5 Bhutan 4. 5 Cambodia 2. 5 Cameroon 4 Gambia 3 Haiti 2. 5 Madagascar 4 Mozambique 3 Papua New Guinea 1. 5 Sierra Leone 2. 5 Sudan 2. 5 Tajikistan 2. 5 Uganda 4 Vietnam 3. 5 Zimbabwe 2. 5 © 2014 Pearson Education, Inc. The scores in this table include factors such as education, mortality, and income growth. A set of environmental criteria including clean air, clean water, and conservation management is also taken into account. 20 of 25

Clean water and clean air are what economists call normal goods. That is, as people get richer, they want to consume more of these goods. FIGURE 17. 3 The Relationship Between Per. Capita GDP and Urban Air Pollution One measure of air pollution is smoke in cities. The relationship between smoke concentration and per-capita GDP is an inverted U: As countries grow wealthier, smoke increases and then declines. © 2014 Pearson Education, Inc. 21 of 25

Much of Southeast Asia has fueled its growth through export-led manufacturing. For countries that have based their growth on resource extraction, there is another set of potential sustainability issues. Because extraction can be accomplished without a well-educated labor force, while other forms of development are more dependent on a skilled-labor base, public investment in infrastructure is especially important. The question of whether the natural resource base imposes strong natural limits on growth has been debated since the time of Malthus. © 2014 Pearson Education, Inc. 22 of 25

In 1972, the Club of Rome, a group of “concerned citizens, ” contracted with a group at MIT to do a study entitled The Limits to Growth. The work involved computer simulations that assumed present growth rates of population, food, industrial output, and resource exhaustion. According to these data, sometime after the year 2000 the limits will be reached and the entire world economy will come crashing down: Collapse occurs because of nonrenewable resource depletion. The industrial capital stock grows to a level that requires an enormous input of resources. In the very process of that growth, it depletes a large fraction of the resource reserves available. As resource prices rise and mines are depleted, more and more capital must be used for obtaining resources, leaving less to be invested for future growth. Finally, investment cannot keep up with depreciation and the industrial base collapses, taking with it the service and agricultural systems, which have become dependent on industrial inputs (such as fertilizers, pesticides, hospital laboratories, computers, and especially energy for mechanization). . Population finally decreases when the death rate is driven upward by the lack of food and health services. © 2014 Pearson Education, Inc. 23 of 25

How should one trade off the obvious gains from growth in terms of the lives of those in the poorer nations against environmental goals? Recognizing the existence of these trade-offs and trying to design policies to deal with them is one of the key tasks of policy makers. © 2014 Pearson Education, Inc. 24 of 25

REVIEW TERMS AND CONCEPTS aggregate production function catch-up disembodied technical change foreign direct investment (FDI) innovation invention labor productivity growth output growth per-capita output growth © 2014 Pearson Education, Inc. 25 of 25