Chapter 7

Economic Growth:
Theory and Policy
Once one starts to think about . . . [differences
in growth rates among countries], it is hard to
think about anything else.
ROBERT E. LUCAS, JR.

Three Pillars of Productivity Growth

Growth policy
High sustainable long-run growth
Potential GDP
Represented by production function

Y=zF(K,L)

Stabilization policy
Keep actual GDP
Close to potential GDP - short run
No high unemployment
No high inflation

Three Pillars of Productivity Growth

Labor productivity grows:
Larger capital stock (K)
Given technology & labor force

Better technology (z)

Given capital & labor

Workforce quality (L)

More education & training
Given capital, technology, labor force

Human capital (education & training)

Amount of skill embodied in workforce
Labor (L) = number of worker (N) * H

Figure 1
Production functions corresponding to three different capital stocks

Output

Yc
Yb

K3

K2

K1

Ya

L1
Hours of Labor Input
4

Levels, Growth Rates, & Convergence

Level of productivity
Higher in rich countries
Depends on
Supply of human & physical capital
State of technology

Growth rate of productivity

Depends on growth rates of
Capital (K)
Workforce skills (H)
Technology (z)

Table 1
Productivity levels and productivity growth rates in selected countries

Country

United
States
France
United
Kingdom
Spain
Ireland
Argentina
Mexico
Brazil
South Korea

GDP per hour of work GDP per hour of work Growt

1980
2005
h
(as percentage of
(as percentage of
rate
U.S.)
U.S.)
100
86
71
62
57
51
44
33
20

100
99
85
62
96
37
25
23
48

1.7
2.3
2.4
1.7
3.9
0.4
-0.5
0.2
5.4

Levels, Growth Rates, & Convergence

Convergence hypothesis
Nations with low levels of productivity
High productivity growth rates

International productivity differences

Shrink over time

Poorer countries
Higher productivity growth

Figure 2
The Convergence Hypothesis

Real GDP per capita

Richer country

Poorer country
$10,000

$2,000
0

Time
8

Levels, Growth Rates, & Convergence

Technological laggards
Can close the income gap
Imitation, not innovation
Adopt existing technologies
Example: Boeing 767 in domestic airline, cell phone
and internet access in China

Convergence club
Productivity growth rates - higher
Where productivity levels are lower (South Korea,
China, India, Ireland, )
Poorest nations
Unable to join

Table 2
Levels and growth rates of GDP per capita in selected poor countries

Country

GDP per
capita
2005*

GDP per capita

growth rate,
1990-2005

Belarus
Russia
Ukraine
Peru
Haiti
Burundi
Sierra
Leone

$1,868
2,445
960
2,337
434
105
218

2.0%
-0.4
-2.4
2.3
-2.4
-2.5
-0.9

*in constant 2000 U.S. dollars

10

Growth Policy: Capital Formation

Nations capital
Available supply
Plant, equipment, software

Result of past decisions investments

Investment
Flow of resources
Production of new capital

Inputs
Construction of capital

Period of time

11

Growth Policy: Capital Formation

Capital formation
Investment
Process of building up capital stock

Trade-off
More capital formation
Quicker growth
Consume less today

More consumption today

Less capital formation
Slower growth

12

Figure 3

Investment Goods Produced

Choosing between investment and consumption

A
I

D
0

Consumer Goods Produced

13

Growth Policy: Capital Formation

Speed up capital formation / investment
Lower real interest rates
Tax provisions
Technical change
Growth of demand
Political stability
Property rights
Laws and/or conventions
Owners - rights to use their property
14

Table 3
Selected countries ranked by level of investor protection
Country
Singapore
United States
Canada
United Kingdom
Japan
Mexico
India
Sweden
Brazil
Italy
China
Swaziland

Rating (0-10
scale)
9.3
8.3
8.3
8.0
7.0
6.0
6.0
5.7
5.3
5.0
5.0
2.3

15

Growth Policy: Education & Training

More-educated & better-trained workers
Higher productivity
Higher wages

Education policy
Improve quality of education

Earning gap
High school graduates
College graduates

On-the-job-training
Skills acquired at work

16

Figure 4
Wage premium for college graduates over high school graduates

17

Growth Policy: Technological Change

Advancement of technology
More education
Scientific, engineering, managerial

More capital formation

Research & development (R&D)
Inventing new products/processes
Improving existing ones

R&D encouraged by government

Tax credit
Collaborative research
Spending on R&D

18

Productivity Slowdown & Speed-up, U.S.

1948-1973: 2.8%
1973-1995 Productivity slowdown, 1.4%
Lagging investment
High energy prices
Inadequate workforce skills
Not: technological slowdown

19

Figure 5
Average productivity growth rates in the United States, 19482007

20

Productivity Slowdown & Speed-up, U.S.

1995-2007 Productivity speed-up, 2.5%
IT revolution
Surging investment
Falling energy prices
Advances in information technology

21

Growth in the Developing Countries

Poorly endowed with capital
Difficult to accumulate capital

Development assistance foreign aid

Outright grants & Low-interest loans
From rich countries & multinational
institutions
To spur economic development

22

Growth in the Developing Countries

Foreign direct investment
Purchase/construction
Real business assets

Multinational corporations

Low level of technology

Low levels of education & training
Poor geographical conditions
Poor health
Governance
23

Table 4
Average educational attainment in selected countries, 2000
United States
Canada
South Korea
Japan
United Kingdom
Italy
Mexico
India
Brazil
Sudan

12.3
11.4
10.5
9.7
9.4
7.0
6.7
4.8
4.6
1.9

For people older than 25 years

of age

24

From the Long Run to the Short Run

Over long periods of time
Similar growth rates
Actual GDP
Potential GDP

Macroeconomic fluctuations
GDP shrinks recessions

Needed: a short-run theory of AD (next

chapter)
25

Summary
Source of economic growth (K, z, and H)
Convergence hypothesis
Growth policy
Capital formation
Improve education and training
Spur technical change

Productivity slowdown and speed-up

Growth in the developing countries