Chapter 26

Long-Run
Economic
Growth

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 In this chapter you will learn to

1. Describe the costs and benefits of economic growth.

2. Describe the four fundamental determinants of growth in

real GDP.
3. Explain the main elements of Neoclassical growth theory.

4. Describe new growth theories based on endogenous

technical change and increasing returns.

5. Explain why resource exhaustion and environmental

degradation create challenges for public policy directed
at sustaining economic growth.
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 The Nature of Economic Growth

Sustained increases in Y* are a more powerful method of

raising material living standards than the removal of
recessionary gaps.

Even small differences in annual growth rates can result in

significant changes in living standards after many years.

Consider GDP, per capita GDP, and GDP per worker.

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Figure 26.1 Three Aspects of
Economic Growth

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Table 26.1 The Cumulative
Effect of Economic Growth

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Benefits of Economic Growth

1. Rising average Material living standards

2. Alleviation of Poverty
- many do not share directly in the growth
- but redistribution is easier in a growing economy

APPLYING ECONOMIC CONCEPTS 26.1

An Open Letter from a Supporter of

the “Growth Is Good”
School
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Costs of Economic Growth

1. Sacrifice of Current Consumption

- growth is often encouraged by increasing investment
and saving
- this requires less consumption (opportunity cost of
economic growth)

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Figure 26.2 The Opportunity
Cost of Economic Growth

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The Opportunity Cost of Growth

2. Social Costs of Growth

- growth usually involves the displacement of some
firms and workers
- this process involves real transition costs

APPLYING ECONOMIC CONCEPTS 26.2

An Open Letter from a Supporter of the
“Growth Is Bad” School

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Sources of Economic Growth

The four fundamental sources of economic growth are:

1. Growth in the labour force

2. Growth in human capital
3. Growth in physical capital
4. Technological improvement

Different theories emphasize different sources of growth.

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Established Theories of Economic
Growth
Focus on the Long Run

We focus on the long run when real GDP is equal to

potential output, Y*.

We hold Y* constant and let the interest rate be determined

endogenously by desired saving and desired investment.

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Investment, Saving, and Growth

Our model has two parts:

Investment — increases in the stock of capital — lead to

increases in the future level of Y*.

Saving by households (and firms) is used to finance this

investment.
- interest rate is the “price” that equilibrates this market

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Investment, Saving, and Growth

Firms’ investment demand is negatively related to the real

interest rate.
National saving = private saving + public saving
NS = Y* - T - C + (T - G)
= Y* - C - G
If C is negatively related to the interest rate, then NS is
positively related to the interest rate.

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Figure 26.3 The Long-Run Connection
between Saving and Investment

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Figure 26.4 Increases in Investment
Demand and the Supply of National
Saving

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Figure 26.5 Cross-Country
Investment and Growth Rates

Empirically,
countries with
high
investment
rates also
have high
growth rates.

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Neoclassical Growth Theory

This theory begins with the idea of an aggregate production

function:
GDP = FT(L,K,H)
- L is the total amount of labour
- K is the stock of physical capital
- H is the quality of human capital
- T is the state of technology
FT reflects the assumption that changes in technology will
change the production function.
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Properties of the Aggregate
Production Function

Key assumptions about the aggregate production function are:

1. Diminishing marginal product of both K and L

- when either factor is changed in isolation

2. Constant returns to scale

- when both K and L are changed in equal proportions

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Figure 26.6 The Aggregate Production
Function and Diminishing Marginal Returns

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Figure 26.6 The Aggregate Production
Function and Diminishing Marginal Returns

Holding K
constant, increases
in L generate
positive but
diminishing
increments to
output.

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Key Predictions of the
Neoclassical Model

1. According to the law of diminishing returns, the MP of L

eventually falls as each successive unit of L is used (for a
fixed amount of other factors).

 increases in population lead to increases in GDP

but eventually to reductions in per capita GDP

 falling material living standards

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Key Predictions of the
Neoclassical Model

2. Diminishing MP of K also means that capital accumulation

on its own brings smaller and smaller increases in real per
capita GDP.

3. The assumption of constant returns to scale means that if K

and L grow at the same rate there will be no improvements in
material living standards.
 GDP will grow but per capita GDP will be constant.

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The Importance of Technological
Change

In the Neoclassical growth model, technological change is

necessary for sustained growth in living standards.
Much technological change is embodied in new capital
equipment.
 investment is crucial

LESSONS FROM HISTORY 26.1

Should Workers Be Afraid of
Technological Change?

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Can We Measure Technological
Change?
Measuring technological change is difficult.

Robert Solow (MIT)

- his “growth accounting” method estimates technical
change as the part of growth that is unexplained by
capital accumulation or labor-force growth

 the “Solow residual”

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New Growth Theories

Endogenous Technological Change

New growth theory emphasizes the process of innovation

and the incorporation of new technology:

• learning-by-doing
• knowledge transfer
• market structure and innovation
• shocks and innovation

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 Increasing Marginal Returns

New growth theories also emphasize the possibility that

each new increment of investment is more productive than
the last.
- contrasts with the Neoclassical assumption of
diminishing marginal returns.

The sources of increasing returns usually fall into one of two

categories:
• market-development costs
• increasing returns to knowledge

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 Are there Limits to Growth?

Resource Exhaustion

Current technology and resources could not support the entire

world’s population at the average U.S. living standard.
- but absolute limits to growth may not be relevant
- technology is constantly improving, suggesting that
living standards can continually improve
- but technological improvements are not automatic —
they do not “just happen”

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 Are there Limits to Growth?

Pollution
Conscious management of pollution was unnecessary when
the world’s population was one billion people, but such
management has now become a pressing matter.

Conclusion
Growth can help the world address many problems. But
further growth must be sustainable growth, which should be
based on knowledge-driven technological change.

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