Introduction to Unit 14 - Economic Growth

In the final two sections of the course we examine the critical issue of economic growth. We have already studied economic growth earlier in the course by looking at GDP, our most commonly accepted measure of the increase in goods and services produced in an economy. The ultimate goal of economic policy makers is for non-inflationary GDP growth. Failure to deliver often spells political doom.

Consider George Bush, who in early 1991 had one of the highest approval ratings of any president in U.S. history due to the military victory over Iraq's army. Yet he lost a bid for re-election to Bill Clinton in the Fall of 1992. The favorite slogan of the Clinton campaign was "its the economy stupid." Bush was crippled by the 1991 recession and the anemic 1992 recovery. And despite Bob Dole's message of a corrupt leadership and a bankrupt economy, Clinton easily won a second term, riding high on strong economic growth rates.

In these final two parts of the course we will greatly expand our knowledge of economic growth. After covering this material it would be wise to keep things in perspective. Many policy makers have a near myopic fixation on the benefits of economic growth. While growth certainly is desirable, there is no guarantee that all citizens will share in its benefits of higher incomes and living standards. For example, if rapid growth comes at the expense of serious environmental degradation, the short run benefits may be swamped by the long run costs. Economic objectives need to be achieved in the broader context of social and environmental needs.

In this section we will start by looking at what is know as the production function. The production function measures the relationship between inputs (capital and labor) and output (of goods and services), given the technology available to transform our inputs into outputs.

We can write our economic growth rate as equal to the sum of:

1. the growth of the labor force,

2. the growth of the capital stock,

3. and the rate of improvement in technology.

This section will continue by developing a basic model of economic growth. By understanding the basics of growth, we can look at several interesting applications in our next unit. Our growth model is known as the Solow model, named after Robert Solow. We will develop our model in several stages, starting very simply and then adding a few additional layers.

The first concept to understand is the relation between economic growth and increases in our nation's capital stock. Remember that capital is the plant, equipment and machinery used to assist labor in the production process - referred to as investment (I) in our measure of GDP.

Firms undertake investment for two reasons:

• To make new additions to their capital stock, and

• to replace worn out capital that has depreciated.

Make sure you understand the difference between the two. For example, assume that you are at work and your computer's hard drive crashes and is replaced by another with similar attributes. The purchase of the hard drive is considered investment, but only to replace depreciated capital - things wear out and need to be replaced to maintain the quality of the capital used. On the other hand, if an extra hard drive, a CD ROM or even a new improved computer was added or purchased, then this is considered to be a net addition to the capital stock.

We also need to consider the source of funds that makes investment possible, where investment can be undertaken to replace depreciated capital or for net investment in new additions to the capital stock. Savings provides the funds for firms to undertake investment.

Step 1: Net investment equals total savings minus the savings necessary to replace the part of the capital stock that has depreciated. The rate of economic growth equals the rate of net additions to the capital stock. Growth results from improvements in worker productivity as the new capital is added.

In our first step we take the total amount of savings available for firms to invest and look at how they break it up. The first priority of the firm is to replace depreciated capital in order to maintain a constant level of worker productivity. Consider a construction firm. Assume each carpenter has his or her own hammer. Sid and Nancy can both install 12 nails a minute on a good day. Now assume that one of the two hammers breaks, and they have to share the remaining one. Worker productivity will plummet. The first priority of the boss is to replace the broken hammer to maintain worker productivity at its previous level.

Now lets take the case where the boss gives each worker a new turbo nail gun as a Christmas bonus. The smart boss realizes that his capital investment has also boosted worker productivity and both Sid and Nancy can now install 25 nails per minute. Thus, net additions to the capital stock raises worker productivity and correlates to the rate of economic growth. Increases in the savings rate will increase the rate of capital accumulation and also the rate of economic growth.

In our first layer of our growth model, the rate of economic growth is determined by the rate of net investment. If there is a 1% net increase in the capital stock each year, then economic growth also equals 1%. Our second layer of the model involves the relaxation of our assumption that labor force growth equals zero (#1 above). Now we allow for a positive level of labor force growth.

Step 2: Net investment equals total savings minus the savings necessary to replace the part of the capital stock that has depreciated plus the capital needed to equip new workers entering the labor force. The rate of economic growth equals the rate of net additions to the capital stock and the labor force (or population) growth rate. Growth results from increases in worker productivity and increases in the total number of workers.

Here we gain additional realism in our growth model. The rate of economic growth is equal to the rate of increase in our country's capital stock plus the labor force growth rate. However, allowing for the labor force to grow is not a simple boost to growth. In order for new workers to be as efficient as their counterparts, they require comparable capital to work with. Imagine an engineering firm that hands their new employee a slide rule, while all of his or her coworkers have high powered computers to work with. The new employee will lag seriously in productivity. Thus we assume that firms give the new workers they hire the same capital to work with as existing workers, in order to maintain a constant level of worker productivity or output per worker.

Equipping new workers with capital diverts some savings away from undertaking net investment. In this case, net additions to the capital stock equals the portion of total savings that is not used to offset depreciation and equip new workers with their share of capital.

Finally, we add our final layer of realism to the model by allowing for improvements in technology.

Technological improvements add to economic growth in the same way that increases in the capital stock do: by increasing worker productivity. By having better capital equipment to use, workers can produce more per hour or day. Consider how the rapid evolution of the personal computer has contributed to our productivity. An important consideration for an economy to reap the benefits of improved technology is that the technology must be used. If you are using a 1986 vintage PC, then you are not taking advantage of the tremendous gains in computer speed offered by the Pentium. As a result, part of a country's total saving must also be devoted to updating its capital stock.

So we have the growth model. We finish this section by defining what is known as the steady state of economic growth. The steady state economic growth rate is achieved when all savings is devoted to offsetting depreciation, equipping new workers with capital and updating existing capital to keep pace with technological advancement. After covering all of these, there is no savings left over for the sole purpose of expanding the capital stock.

Note that in the steady state, the capital stock does increase, but it increases along with the workforce.

We use the concept of the steady state to describe a developed economy in contrast to a developing economy. Developed economies like the U.S. and Japan are considered to have attained their steady state growth rate. Annual real economic growth equals the labor force growth rate plus the rate of improvement in worker productivity. In the United States, the labor force is estimated to increase by about 1.5% a year, and worker productivity approximately 1.0% annually, yielding a 2.5% rate of supply side economic growth.

This takes us back to the beginning of the course where we described the expansion of a country's production possibilities frontier and its rate of supply side economic growth.

LINK TO MAIN SECTION OF UNIT 14 - ECONOMIC GROWTH