Chapter 11 Long run economic growth sources and policies Economic growth occurs when Real GDP per capita increase Economic growth over time and around the world With economic growth an economy produces both increasing quantities of goods and services and better goods and services Significant economic growth did not begin until the Industrial revolution o Industrial Revolution the application of mechanical power to the production of goods beginning in England around 1750 Sustained increases in real GDP per capita eventually raised living standards in those countries to the high levels of today Small differences in growth rates are important In the long run small differences in economic growth rates result in big differences in living standards The principle of compounding applies to economic growth rates as well as to interest rates long periods of time o Compounding magnifies even small differences in interest rates over Why do growth rates matter An economy that grows too slowly fails to raise living standards Countries that experience slow growth have also missed opportunities to improve the lives of their citizens High income industrial countries Western Europe Australia Canada New Zealand United States Japan Developing countries Africa Asia Latin America Newly industrializing countries Singapore South Korea Taiwan What determines how fast economics grow Economic growth model a model that explains growth rates in real GDP per capita over the long run o Focuses on technological change and changes over time in the quantity of capital available to workers in explaining changes in real GDP per capita Labor productivity the quantity of goods and services that can be produced by one worker or by one hour of work Technological change a change in the quantity of output a firm can produce using a given quantity of inputs o Better machinery and equipment o Increase in human capital o Better means of organizing and managing production The per worker production function When analyzing economic growth we look at increase in real GDP per hour worked and increases in capital per hour worked Per work production function the relationship between real GDP per hour worked and capital per hour worked holding the level of technology constant Law of diminishing returns as we add more of one input capital to a fixed quantity of another input labor output increases by smaller additional amounts Technological change helps economies avoid diminishing returns to capital o Shifts up the per worker production function and allows an economy to produce more real GDP per hour worked with the same quantity of capital per hour worked o In the long run a country will experience an increasing standard of living only if it experiences continuing technological change New Growth Theory a model of long run economic growth that emphasizes that technological change is influenced by economic incentives and so is determined by the working of the market system Knowledge capital o Nonrival and nonexcludable o Firms free ride At the firm level as firms add to their stock of knowledge capital they increase their output but at a decreasing rate At the entire economy level knowledge capital is subject to increasing returns Government policy can help increase the accumulation of knowledge capital o Protecting intellectual property with patent and copyright Patent the exclusive right to produce a product for a period of 20 years from the date the patent is applied for o Subsidizing research and development o Subsidizing education Increase the quantity of capital per house worked Use the best available technology The economic growth model predicts that poor countries will grow faster than rich countries Catch up the prediction that the level of GDP per capita in poor countries will grow faster than in rich countries Why have other high income countries had trouble closing the gap completely in real GDP per capita with the US The greater flexibility of US labor markets The greater efficiency of the US financial system Liquidity quickly sell the stocks and bonds purchased Why are many low income countries growing so slowly hindered economic growth Failure to enforce the rule of law o Property rights the rights individuals or firms have to the exclusive use of their property including the right to buy or sell it o Rule of law the ability of a government to enforce the laws of the country particularly with respect to protecting private property and enforcing contracts Wars and revolutions Poor public education and health Low rates of saving and investment Benefits of Globalization Foreign direct investment the purchase or building by a corporation for a facility in a foreign country Foreign portfolio investment the purchase by an individual or a firm of stocks or bonds issued in another country FDI and FPI can give a low income country access to funds and technology that otherwise would not be available Globalization the process of countries becoming more open to foreign trade and investment Globalization and growth are strongly positively associated Growth policies High pay off to government policies that increase growth rates Enhancing property rights and the rule of law o The rule of law and property rights are undermined by government corruption o Increased political stability is a necessary prerequisite to economic growth Improving health and education o Poor health is a major impediment to growth in some countries o As peoples health improves and they become stronger and less susceptible to disease they also become more productive o The rising incomes that result from economic growth can help developing countries deal with the brain drain Brain drain refers to highly educated and successful individuals leaving developing countries for high income countries Policies that promote technological change o Technological change is more important than increases in capital in explain long run growth o Easiest way for developing countries to gain access to technology is through foreign direct investment o In high income countries government policies can aid the growth of technology by subsidizing research and development Polices that promote saving and investment o Polices that increase the incentives to save and invest will increase the equilibrium level of loanable funds and may increase the level of real GDP per capita o Investment tax credit allow firms to deduct from their taxes some fraction of the funds they have spend on