Week 12 The Economy in the Long Run: Economic Growth Reference: Bernanke, Olekalns and Frank Chapter 10, 11

Key Issues Real GDP per capita The production function Cobb-Douglas Growth accounting

Measuring Economic Growth Conventional to use real GDP per capita as a measure of a countrys living standards and stage of economic development Real GDP per capita:
GDP Y y= = POP POP

We know from Week 1, that GDP is not a perfect measure of economic wellbeing; however it does seem to be positively related to life expectancy, infant health etc.

$, annual rates 10,000 20,000 30,000 40,000 50,000 60,000

Sep-73 Sep-75 Sep-77 Sep-79 Sep-81 Sep-83 Sep-85 Sep-87 Sep-89 Sep-91 Sep-93 Sep-95 Sep-97 Sep-99 Sep-01 Sep-03 Sep-05 Sep-07

Quarterly Real GDP per Capita for Australia (1973-2009)

Long Term Economic Growth in OECD Countries

Rule of 70

0 Macroeconomics

Growth Facts There are large differences in the level of real GDP per capita across countries $US (1985 prices) US Japan China South Korea Chad 1990 18,073 14,317 1,324 6,665 400 An important cause of this inequality is the fact that countries grow at different rates. Average % per annum US Japan China South Korea Chad 60-90 1.4 5.0 2.4 6.0 -1.7
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Growth Questions
Wh What t factors f t caused d some countries t i to t grow fast f t and d others to grow slow over periods such as 1960 to 2000? (East Asia vs. Sub-sahara) ( )

How did countries such as the United States and other OECD members sustain growth rates of real GDP per person of around 2% per year for a century or more?

What can policymakers do to increase growth rates of per p person? real GDP p
Macroeconomics Chapter

Small Differences in Growth Rates Have Big Level Effects Why some countries can grow rapidly; while others lag far behind; is an important question. Small differences in growth rates, maintained over many years, can make large differences in living standards. Country Growth Rate A 1% B 2% Initial Income 1000 1000 Income after x years 5 25 35 1051 1284 1419 1105 1649 2013
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Macroeconomics 2. Ref: Barro Chapter 3

Decomposing Changes in GDP per Capita We can re-write real GDP per capita in the following way:
GDP GDP N = POP N POP

where N is employed workers. The right-hand-side is Average labour productivity (GDP/N) (times) Share of population in employment (N/POP)

Growth in Australian Real GDP per Capita Real GDP per capita can only grow if labour productivity grows, and/or the employment share grows From 1965 and 2006, real GDP per capita grew by 108%. share of population working grew from 66% to 74%; as women participated more fully in the workforce average labour productivity increased by 87%

Influences on Labour Productivity Human Capital Physical Capital per worker Land and Natural Resources Technology Management Political and Legal Environment
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Costs and Limits to Economic Growth Can economic growth continue indefinitely without depleting natural resources and causing massive change to the global environment? Are there limits to growth? Growth in real GDP can be in the form of new or higher quality products Higher levels of real GDP per person are associated with lower levels of pollution Market prices can adjust for shortages in resources
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Production Functions Production functions will be familiar from microeconomics where we can represent the output of an individual firm as a function of its inputs. No. of computers produced by a firm depends on: Number of workers Quantity of capital In macroeconomics we represent aggregate output (GDP) by a production function.
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Aggregate Production Functions Assume that level of real output (Y) depends upon three things: aggregate labour input (L) aggregate capital stock (K) the state of technology (A) Formally
Y = A f ( L, K )

The exact form of the function f (.) is not specified

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Properties

Y = A f ( L, K )

Marginal products of labour and capital are: positive

MPK = Y = A f K ( L, K ) > 0 K MPL = Y = A f L ( L, K ) > 0 L

diminishing
K MPK L MPL
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Demand for Labour Labour will be used up to the point where

W P W MPL = P

MPL

L
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Demand for Capital Capital will be used up to the point where MPK = r
r

MPK

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Macroeconomics 2. Ref: Barro Chapter 3

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Macroeconomics 2. Ref: Barro Chapter 3

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Production Functions
MPL Marginal product of labor (Y/ L)
Assumption p 1: Diminishing g Marginal g Product of labor

MPK Marginal product of capital (Y/ K)

Assumption 2: Diminishing Marginal Product of Capital

Macroeconomics 2. Ref: Barro Chapter 3

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Constant Returns to Scale (CRS)

Assumption 3: Constant Returns to Scale
Double K and L and Y will also double More formally, Y = A F(K, L)

Let this =1/L, then we have Y/ L = A F( K / L, L/ L) Call Y/L=y (output per worker) and K/L=k ( (capital per worker) )
Macroeconomics 2. Ref: Barro Chapter 3 18

Cobb-Douglas Production Function Marginal Products

Y = AK L1

1 Y L = (1 ) AK L = (1 ) AK L = (1 ) AK L1 L L L
Y MPL = (1 ) L

Marginal product of labour Marginal product of capital

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MPK =

Y K

Factor Incomes Exhaust Total Output Suppose labour and capital are paid their marginal products. (Real) labour income = (Real) capital income =
W Y L = MPL L = (1 ) L P L
r K = MPK K = Y K K

labour income + capital income = Y

(1 )Y + Y = Y

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Contributions to Economic Growth Suppose we believe that the Cobb-Douglas function provides a good model for aggregate output in an economy.

Y = AK L1
It must be the case that all changes in Y can be accounted for by changes in labour, capital or technology. Growth accounting

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A Result on Logarithms Suppose

z = xa Take logs of both sides log z = a log x Take the difference of both sides log z = a log x z log z Note that z z x =a So z x
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Decomposing Output Growth Production function for output in period (t):

Yt = At K t L1 t

Use the above result to write

Yt Yt 1 At At 1 K K t 1 L Lt 1 = + t + (1 ) t Yt 1 At 1 K t 1 Lt 1

or
Yt At K t Lt = + + (1 ) Yt 1 At 1 K t 1 Lt 1

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Contributions to Output Growth

Yt At K t L = + + (1 ) t Yt 1 At 1 K t 1 Lt 1

In any period output growth is due to: growth in technology;

At At 1

growth in capital (weighted by ); growth in labour (weighted by 1-);

K t K t 1

Lt (1 ) Lt 1
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Estimating the Growth Rate of Technology While we potentially have direct measures of output, labour and capital, this is not so for technology. However write
At Yt K t Lt = (1 ) At 1 Yt 1 K t 1 Lt 1

Then given data on the growth rates of ouput, labour and capital and a value for , we can estimate the growth rate of technology.

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Estimating We showed earlier that

MPK = Y K

Now re-arrange to get

MPK K = Y rK = Y

If capital is paid its marginal product so the left-hand side is just capitals share of total output, and we can use this figure as an estimate for .
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Decomposition of Output Growth for Australias Market Sector Period 1965-1970 1970-1980 1980-1990 1990-2000 2000-2005 Y/Y 5.1 2.9 3.2 3.2 2.8 Annual Growth Rates K/K + (1-) L/L 4.0 1.4 2.4 1.7 2.2 2.1 A/A 1.1 1.6 0.8 1.5 0.6 1.2

1965-2005 3.3 Source: ABS

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