Principles of Macroeconomics

Lecture 4

ECONOMIC GROWTH & DEVELOPMENT

The World Economy

Total GDP (2008): $70T Population (2009 est): 6.8B GDP per Capita: $10,000 Population Growth: 1.17% GDP Growth (2008 est.): 3.8%

GDP per capita is probably the best measure of a country’s well being

Region GDP % of World GDP

GDP Per Capita

Real GDP Growth

United States $14T 20% $47,000 1.3%

European Union $15T 21% $33,000 1.0%

Japan $4.3T 6% $34,200 -.4%

China $7.8T 11% $6,000 9.8%

India $3.2T 5% $2,800 6.6%

Ethiopia $66.3B .09% $800 8.5%

The World Economy

Source: CIA World Factbook

Currently, GDP per capita in the US is around 8 times that in China. However, at the current growth rates, that will shrink to a factor of 1.5 over the next two decades!

ChinaGDP/Capita: $6,000GDP Growth: 9.8%

United StatesGPD/Capita: $47,000GDP Growth: 1.3%

853,60$013.1000,47$ 20

922,38$098.1000,6$ 20

The World Economy

The World EconomyP

er C

apit

a In

com

e

Income GDP/Capita GDP Growth

Low $510 6.3%

Middle $2,190 7.0%

High $32,040 3.2%

As a general rule, low income (developing) countries tend to have higher average rates of growth than do high income countries

The implication here is that eventually, poorer countries should eventually “catch up” to wealthier countries in terms of per capita income – a concept known as “convergence”

Economic growth

Some countries, however, don’t fit the normal pattern of development

ZimbabweGDP: $2BGDP Per Capita: $200GDP Growth: -12.6%

Macau (China)GDP: $18BGDP Per Capita: $30,000GDP Growth: 15%

So, what is Zimbabwe doing wrong? (Or, what is Macau doing right?)

At current rates, Per capita income is Macau will quadruple to $120,000 over the next decade. This will make Macau the wealthiest country in the world. Over the same time period, per capita GDP in Zimbabwe will drop by roughly 75%to $52!!!

Economic growth

To understand this, let’s look at the sources of economic growth….where does production come from?

“is a function of”

LKAFY ,,Real GDP

Productivity Capital Stock

Labor

Real GDP = Constant Dollar (Inflation adjusted) value of all goods and services produced in the United States

Capital Stock = Constant dollar value of private, non-residential fixed assets

Labor = Private Sector Employment

Productivity = Production unaccounted for by capital or labor

Growth accounting breaks down GDP growth into growth of the three factors.

Starting with a production function, take the complete derivative…

LKAFY ,,

dLdL

dYdK

dK

dYdA

dA

dYdY

Change in production

Change in production per unit change in A

Change in A

The World Economy

1939 - 1948 1948 - 1973 1973-1993 1993-2007

Output 5.79 4.10 1.96 2.63Capital 3.34 4.24 2.10 2.94Labor 4.46 2.10 1.86 1.60Productivity 1.71 1.28 0.02 0.59

Some facts to notice:

- Real GDP growth is declining over time.

- Capital has been growing faster than labor

Contributions to growth from capital, labor, and technology vary across time period

The World Economy

A better measure of economic well being is per capita GDP, so let us convert variables to per capita terms

3

2

3

1

LAKY Divide both sides by labor to represent our variables in per capita terms

3

13

13

2

3

1

AkL

KA

L

LAK

L

Yy

Capital/Labor Ratio

Productivity (Technology)

Per capita output

In general, let us assume lower case letters refer to per capita variables

Capital exhibits diminishing marginal productivity – that is as capital relative to labour rises, its contribution to production shrinks

3

1

Aky y

k

Economic Growth

Economic Growth

Most countries follow the “usual” pattern of development

1 Developing countries have very little capital, but A LOT of labour. Hence, the price of labor is low, the return to capital is very high

2 High returns to capital attract a lot of investment. As the capital stock grows relative to the labour force, output, consumption, and real wages grow while interest rates (returns to capital fall)

3 Eventually, a country “matures” (i.e. reaches its steady state level of capital). At this point, growth can no longer be achieved by investment in capital. Growth must be “knowledge based” – improving productivity! That means technological improvement!

Productivity

3

1

Aky

Economic Development

Developing countries are well below their steady state and, hence should grow faster than developed countries who are at or near their steady states – a concept known as absolute convergence

Examples of Absolute Convergence (Developing Countries)China (GDP per capita = $6,300, GDP Growth = 9.3%)

Armenia (GDP per capita = $5,300, GDP Growth = 13.9%)

Chad (GDP per capita = $1,800, GDP Growth = 18.0%)

Angola (GDP per capita = $3,200, GDP Growth = 19.1%)Examples of Absolute Convergence (Mature Countries)Canada (GDP per capita = $32,900, GDP Growth = 2.9%)

United Kingdom (GDP per capita = $30,900, GDP Growth = 1.7%)

Japan (GDP per capita = $30,700, GDP Growth = 2.4%)

Australia (GDP per capita = $32,000, GDP Growth = 2.6%)

Economic Development

Some countries, however, don’t fit the traditional pattern.

Developing Countries with Low Growth

Zimbabwe (GDP per capita = $2,100, GDP Growth = - 7.0%)

Iraq (GDP per capita = $3,400, GDP Growth = - 3.0%)

North Korea (GDP per capita = $1,800, GDP Growth = 1.0%)

Haiti (GDP per capita = $1,600, GDP Growth = 1.5%)

Developed Countries with high Growth

Hong Kong (GDP per capita = $37,400, GDP Growth = 6.9%)

Iceland (GDP per capita = $34,900, GDP Growth = 6.5%)

Singapore (GDP per capita = $29,900, GDP Growth = 5.7%)

Economic Development

y

Steady State

(Haiti)

High Population Growth (Haiti)

Low Population Growth (Argentina)

Haiti

Population Growth: 2.3%

GDP/Capita: $1,600

GDP Growth: -1.5%

Argentina

Population Growth: .96%

GDP/Capita: $13,700

GDP Growth: 8.7%Steady State

(Argentina)

Haiti is currently ABOVE its steady state (GDP per capita is falling due to a high population growth rate

Argentina, with its low population growth is well below its steady state growing rapidly towards it

Conditional convergence suggests that every country converges to its own unique steady state. Countries that are close to their unique steady state will grow slowly while those far away will grow rapidly.

Economic Development

l

y

Steady State

(Zimbabwe)

High Savings Rate (Hong Kong)

Low Savings Rate (Zimbabwe)

Zimbabwe

GDP/Capita: $2,100

GDP Growth: -7%

Investment Rate (%0f GDP): 7%

Hong Kong

GDP/Capita: $37,400

GDP Growth: 6.9%

Investment Rate (% of GDP): 21.2%Steady State

(Hong Kong)

Zimbabwe is currently ABOVE its steady state (GDP per capita is falling due to low investment rate

Hong Kong, with its high investment rate is well below its steady state growing rapidly towards it

Economic Development

l

y

Steady State

(France)

Small Government (US)

Large Government (France)

France

GDP/Capita: $30,000

GDP Growth: 1.6%

Government (%0f GDP): 55%

USA

GDP/Capita: $42,000

GDP Growth: 3.5%

Government (% of GDP): 18%Steady State

(USA)

France has a lower steady state due to its larger public sector. Even though its per capita income is lower than the US, its growth is slower

The smaller government of the US increases the steady state and, hence, economic growth

Economic Development

Suggestions for growth

High income countries with low growth are at or near their steady state. Policies that increase capital investment will not be useful due to the diminishing marginal product of capital.

- Consider investments in technology and human capital to increase your steady state.

- Consider limiting the size of your government to shift resources to more productive uses (efficiency vs. equity)

Low income countries with low growth either have a low steady state or are having trouble reaching their steady state

- Consider policies to lower your population growth.

- Try to increase your pool of savings (open up to international capital markets)

- Policies aimed at capital formation (property rights, tax credits, etc).

Economic Development

Helpful Reading

Economics. Samuelson, & Nordhaus (2005) Ch. 27-28