- Study Guide (Course-wide Content)
A. Theories of Economic Growth
- The analysis of economic growth examines the factors that lead to the growth of potential output over the long run. The growth in output per capita is an important objective of government because it is associated with rising average real incomes and living standards.
- Reviewing the experience of nations over space and time, we see that the economy rides on the four wheels of economic growth: (a) the quantity and quality of its labor force; (b) the abundance of its land and other natural resources; (c) the stock of accumulated capital; and, perhaps most important, (d) the technological change and innovation that allow greater output to be produced with the same inputs. There is no unique combination of these four ingredients, however; the United States, Europe, and Asian countries have followed different paths to economic success.
- The classical models of Smith and Malthus describe economic development in terms of land and population. In the absence of technological change, increasing population ultimately exhausts the supply of free land. The resulting increase in population density triggers the law of diminishing returns, so growth produces higher land rents with lower competitive wages. The Malthusian equilibrium is attained when the wage rate has fallen to the subsistence level, below which population cannot sustain itself. In reality, however, technological change has allowed long-term growth in real wages and productivity per worker in most countries by continually shifting the productivity curve of labor upward.
- Capital accumulation with complementary labor forms the core of modern growth theory in the neoclassical growth model. This approach uses a tool known as the aggregate production function, which relates inputs and technology to total potential GDP. In the absence of technological change and innovation, an increase in capital per worker (capital deepening) would not be matched by a proportional increase in output per worker because of diminishing returns to capital. Hence, capital deepening would lower the rate of return on capital (equal to the real interest rate under risk-free competition) while raising real wages.
- Technological change increases the output producible with a given bundle of inputs. This pushes upward the aggregate production function, making more output available with the same inputs of labor and capital. Recent analysis in the "new growth theory" seeks to uncover the processes which generate technological change. This approach emphasizes (a) that technological change is an output of the economic system, (b) that technology is a public or nonrival good that can be used simultaneously by many people, and (c) that new inventions are expensive to produce but inexpensive to reproduce. These features mean that governments must pay careful attention to ensuring that inventors have adequate incentives, through strong intellectual property rights, to engage in research and development.
- Numerous trends of economic growth are seen in data for the twentieth and early twenty-first centuries. Among the key findings are that real wages and output per hour worked have risen steadily; that the real interest rate has shown no major trend; and that the capital-output ratio has declined. The major trends are consistent with the neoclassical growth model augmented by technological advance. Thus economic theory confirms what economic history tells us—that technological advance increases the productivity of inputs and improves wages and living standards.
- The last trend, continual growth in potential output since 1900, raises the important question of the sources of economic growth. Applying quantitative techniques, economists have used growth accounting to determine that "residual" sources—such as technological change and education—outweigh capital deepening in their impact on GDP growth and labor productivity.
- After 1970, productivity growth slowed under the weight of energy-price increases, increasing environmental regulation, and other structural changes. In the late 1990s, however, the explosion of productivity and the investment in computers and other information technologies have led to a sharp upturn in measured productivity growth.