Economic Growth

Causes of economic growth

Economic growth has two meanings:

1. Actual growth: Firstly, and most commonly, growth is defined as an increase in the output that an economy produces over a period of time, the minimum being two consecutive quarters.

2. Potential growth: The second meaning of economic growth is an increase in what an economy can produce if it is using all its scarce resources. An increase in an economy’s productive potential can be shown by an outward shift in the economy’s production possibility frontier (PPF).

Production Possibility Frontier

Production possibility curves are also known as production possibility frontiers. What a PPF curve shows is the total combination of goods and services a country can produce with its fixed level of resources. It highlights the concept of scarcity and opportunity cost. (e.g. how if you want more production of staple foods you would to reduce production of cash crops). A production possibility curve can show how the economy of a country is doing.

A production possibility frontier is curved because of the law of diminishing returns which occurs because the workers who specialize in the production of one service is not as efficient as the production of another good or service.

Economic growth is when the economy increases productivity or the level of resources. It is represented by the outward shift of the PPC curve from PPC1 to PPC2. The potential output of the economy rises.(Potential output is when resources are fully utilized at the maximal efficiency)

Actual growth occurs when the economy decides to utilize more resources or decides to use it more efficiently hence increasing output. This is represented by the movement of the production point X to point Y. The respective outputs can be found by drawing lines to the axis.

Source - http://ib-economics.blogspot.hk/2009/05/production-possibility-frontier.html

Methods of illustrating economic growth

The simplest way to show economic growth is to bundle all goods into two basic categories, consumer and capital goods. An outward shift of a PPF means that an economy has increased its capacity to produce.

What creates growth?

When using a PPF, growth is defined as an increase in potential output over time, and illustrated by an outward shift in the curve. An outward shift of a PPF means that an economy has increased its capacity to produce all goods. This can occur when the economy undertakes some or all of the following:

Employs new technology

Investment in new technology increases potential output for all goods and services because new technology is inevitably more efficient than old technology. Widespread 'mechanization' in the 18th and 19th centuries enabled the UK to generate vast quantities of output from relatively few resources, and become the world's first fully industrialized economy. In recent times, China's rapid growth rate owes much to the application of new technology to the manufacturing process.

An economy will not be able to grow if an insufficient amount of resources are allocated to capital goods. In fact, because capital depreciates some resources must be allocated to capital goods for an economy to remain at its current size, let alone for it to grow.

Employs a division of labour, allowing specialisation

A division of labour refers to how production can be broken down into separate tasks, enabling machines to be developed to help production, and allowing labour to specialize on a small range of activities. A division of labour, and specialization, can considerably improve productive capacity, and shift the PPF outwards.

Employs new production methods

New methods of production can increase potential output. For example, the introduction of team working to the production of motor vehicles in the 1980s reduced wastage and led to considerable efficiency improvements. The widespread use of computer controlled production methods, such as robotics, has dramatically improved the productive potential of many manufacturing firms.

Increases its labour force

Growth in the size of the working population enables an economy to increase its potential output. This can be achieved through natural growth, when the birth rate exceeds the death rate, or through net immigration, when immigration is greater than emigration.

Discovers new raw materials

Discoveries of key resources, such as oil, increase an economy’s capacity to produce.

An inward shift of a PPF

A PPF will shift inwards when an economy has suffered a loss or exhaustion of some of its scarce resources. This reduces an economy's productive potential.

A PPF will shift inwards if:

Resources run out

If key non-renewable resources, like oil, are exhausted the productive capacity of an economy may be reduced. This happens more quickly as a result of the application of ultra-efficient production methods, and when countries over-specialize in producing goods from non-renewable resources.

Sustainable growth means that the current rate of growth is not so fast that future generations are denied the benefit of scarce resources, such as non-renewable resources, and a clean environment.

Failure to invest

A failure to invest in human and real capital to compensate for depreciation will reduce an economy's capacity. Real capital, such as machinery and equipment, wears out with use and its productivity falls over time. As the output from real capital falls, the productivity of labour will also fall. The quality and productivity of labour also depends on the acquisition of new skills. Therefore, if an economy does not invest in people and technology its PPF will slowly move inwards.

Erosion of infrastructure

A military conflict is likely to destroy factories, people, communications, and infrastructure.

Natural disaster

If there is a natural disaster, such as the 2005 boxing-day tsunami, or the Haiti earthquake of 2010, an economy’s PPF will shift inwards.

Investment and economic growth

Allocating scarce funds to capital goods, such as machinery, is referred to as real investment. If an economy chooses to produce more capital goods than consumer goods, at point A in the diagram, then it will grow by more than if it allocated more resources to consumer goods, at point B, below.

To achieve long run growth the economy must use more of its capital resources to produce capital rather than consumer goods. As a result, standards of living are reduced in the short run, as resources are diverted away from private consumption. However, the increased investment in capital goods enables more output of consumer goods to be produced in the long run. This means that standards of living can increase in the future by more than they would have if the economy had not made such as short-term sacrifice. Hence economies face a choice between high levels of consumption in the short run and the long run.

Investment

If an economy chooses to produce more capital goods than consumer goods, at point A in the diagram, then it will grow by more than if it allocated more resources to consumer goods, at point B.

There is a trade-off between the short and the long run. In the short run, the economy must use resources to produce capital rather than consumer goods. Standards of living are reduced in the short run, as resources are diverted away from private consumption. However, in the longer run the increased investment in capital goods enables more output of consumer goods to be produced. This means that standards of living can increase by more than they would have if the economy had not made the short-term sacrifice.

Asymmetric growth

An economy can grow because of an increase in productivity in one sector of the economy - this is called asymmetric growth.

For example, an improvement in technology applied to industry Y, such as motor vehicles, but not to X, such as food production, would be illustrated by a shift of the PPF from the Y-axis only.

Task 4: Use Figure 1-2.7 to answer the following 5 questions. Each curve starts with Curve BE as a country’s curve.

a) Suppose there is a major technological breakthrough in the consumer-goods industry, and the new technology is widely adopted. Which curve in the diagram would represent the new PPC? Indicate the curve you choose with two letters.

b) Suppose a new government comes into power and forbids the use of automated machinery and modern production techniques in all industries. Which curve in the diagram would represent the new PPC? Indicate the curve you choose with two letters.

c) Suppose new sources of oil and coal are found within the economy and there are major technological innovations in both industries. Which curve in the diagram would represent the new PPC? ? Indicate the curve you choose with two letters.

d) IF BE represents a country’s current PPC, what can you say about a point like X?

e) IF BE represents a country’s current PPC, what can you say about a point like Y?

The sources of economic growth – importance of productivity

Real GDP grows when the quantities of the factors of production grow or when persistent advances in technology make them increasingly productive. All the influences on real GDP growth can be divided into those that increase

• Aggregate hours
• Labour productivity

Aggregate Hours

Over time aggregate hours increase. In developed economies, this growth in aggregate hours comes from growth in the labour force rather than growth in average hours per worker.

Population growth brings economic growth but it does not bring growth in real GDP per capita unless labour hours become more productive.

Labour Productivity

The quantity of real GDP produced by one hour of labour is called labour productivity. It is calculated by using the formula:

Labour productivity = real GDP/aggregate hours

For example, if real GDP is $8000 billion and if aggregate hours are 200 billion, then we can calculate labour productivity as:

Labour productivity = $8000 billion/200 billion = $40 per hour

You can turn this formula around and see that:

Real GDP = Aggregate hours x labour productivity

When labour productivity grows, real GDP per capita grows. So the growth in labour productivity is the basis of rising living standards. The growth of labour productivity depends on three things:

• Savings and investment in physical capital – increase the amount of capital per worker and increase labour productivity
• Expansion of human capital – human capital which is the accumulated skills and knowledge of people comes from education & training and job experience
• Discovery of new technologies – the development of writing, development of mathematics which laid the foundation for the eventual extension of knowledge in the sciences and more advanced technologies embodied in physical capital have laid the conditions for great spurts in economic growth in the last 200 years.

Robert Solow’s One-third rule

This is an observation discovered by Robert Solow of MIT. One average, with no change in human capital and technology, a 1% increase in capital per hour of labour brings a one-third percent increase in labour productivity.

We can use the one –third rule to identify the contribution of capital growth to labour productivity growth. Suppose, for example, that in a year, capital per hour of labour grows by 3% and labour productivity grows by 2.5%. The one-third rule tells us that capital growth has contributed one-third of 3% which is 1%.

Labour productivity growth that is not attributed to capital growth arises from human capital growth and technological change. In the above example in which labour productivity grows by 2.5% and capital growth contributed 1%, the remaining 1.5% growth of labour productivity comes from human capital growth and technological change.

See - Why the cities you’ve never heard of are poised to lead China’s economic growth - http://www.scmp.com/business/china-business/article/2069534/why-cities-youve-never-heard-are-poised-lead-chinas-economic

Task 5:

Output Gap

The output gap is a measure of the difference between actual output (Y) and potential output (Yf).

The output gap = Y- Yf

Negative Output Gap

This occurs when actual output is less than potential output gap. This is also called a deflationary (or recessionary) gap. In this situation the economy is producing less than potential. There will be unemployment, low growth and / or a fall in output. A negative output gap will typically cause low inflation or even deflation.

Positive Output Gap

This occurs when actual output is greater than potential output. This will occur when economic growth is above the long run trend rate (e.g. during an economic boom). It will involve firms asking workers to overtime.

With a positive output gap, there will be inflationary pressures. It will also tend to cause a bigger current account deficit as consumers buy more imports due to domestic supply constraints.

Output Gap.

HM treasury forecast an output gap of -2.7% for 2012/13. This is the amount of spare capacity they feel the UK has.

Note: it can be difficult to measure the amount of spare capacity – See: What is the UK’s actual output gap?

Lost Output During 2008-12 Recession

This shows how actual real GDP fell behind the trend growth rate of GDP.

Potential Output

Potential gross domestic product (GDP) is a theoretical concept that means different things to different people. To some, it reflects a world in which every worker is matched with the perfect job, every good idea is implemented, and the bad ones are ignored. In this world, resources are allocated optimally with no distortions from the tax code, information frictions, or suboptimal government policies.

But this theoretical “perfect world” is not the real world, and the scenario just described is not the concept of potential GDP monetary policymakers typically use when setting monetary policy. Instead, they estimate potential GDP by constructing measures of the trend in actual GDP that smooth out business cycle fluctuations. Looking back in time, potential output is relatively easy to measure because we have reliable methods to extract smooth trends from historical data. However, measuring potential output in real time is more difficult because only past data are available to estimate the trend. We cannot be confident about the estimate of potential GDP for 2012 until several years have passed and we see how GDP evolves—the accuracy of our estimate depends on the accuracy of our long-term forecast. But why does potential GDP matter? How do we use it? Potential GDP is important because monetary policymakers use the difference between actual and potential GDP—the output gap—to determine whether the economy needs more or less monetary stimulus.

One look at recent Congressional Budget Office (CBO) data shows how much estimates of the output gap can change as time passes. According to CBO estimates of potential GDP, U.S. actual GDP fell about 10 percent short of potential during 2009: Q1. Since then, actual GDP has paralleled the potential GDP series forecast made by economists back in 2007—but, of course, along a considerably lower level path. The chart shows logged values of actual GDP and two estimates of potential GDP calculated by the CBO. The higher level of potential GDP was estimated in 2007 and the lower level in 2011. The reduced 2011 estimate reflects the impact of sluggish GDP growth over the past three years.

Task 8: Calculation of the output gap in Hong Kong. Take the natural rate of unemployment s 3.9% (natural rate of employment is 96.1%). Use the information in the following tables to help you calculate the output gap (absolute and as a % of potential GDP) in Hong Kong for the period 2014-2016

Okun’s Law

Okun's law states that a one point increase in the cyclical unemployment rate is associated with two percentage points of negative growth in real GDP. The relationship varies depending on the country and time period under consideration.

The math formula for Okun's Law is:

In other words, when unemployment rate goes up by 1%, GDP goes down by 2%.It's not a perfect fit, but in general the relationship seems to hold true: