CHAPTER 9
ECONOMIC GROWTH AND RISING LIVING STANDARDS
MASTERY GOALS
The objectives of this chapter are to:
1. Explain why economic growth is an important determinant of a nation’s standard of
living.
2. Use the rule of 70 to show how even small differences in economic growth can result in
huge difference in living standards.
3. Explain how economic growth means that poor countries need to not stay poor.
4. List the factors that determine our potential GDP in any given period.
5. Explain why growth in real GDP does not guarantee a rising standard of living
6. Explain how changes in labor supply and labor demand lead to increases in total
employment.
7. List the types of government policies that can increase employment.
8. Explain why population growth, growth in average hours, and increases in the labor force
participation rate cannot explain growth in living standards over the long run.
9. Describe how changes in the capital stock affect living standards.
10. Explain how government policies can affect the amount of investment that occurs in an
economy, and show how changes in investment lead to changes in the capital stock.
11. Explain why some methods of deficit reduction are preferable to others, in terms of
economic growth.
12. Describe the link between growth in human capital and growth in living standards.
13. Describe the government policies that affect human capital growth.
14. Explain the link between technological change and economic growth.
15. Describe how government policies affect the rate of technological change.
16. Understand the concept of catch-up growth and government actions that can contribute to
it.
17. Describe the costs of economic growth.
18. State the reasons why some countries have very low growth rates and discuss the
alternative methods they can employ to break their circle of poverty.
THE CHAPTER IN A NUTSHELL
Economic growth is an important determinant of a nation’s average standard of living. If output
grows faster than the population, the average living standard will rise, but if output grows more
slowly than the population, the average living standard will fall.
We can see how important even small differences in growth rates are by the application of the
rule of 70. Even a 1% increase in the real GDP growth rate can cause a huge increase in living
standards over time.
At first glance, it looks as if poor countries will remain poor regardless of circumstance.
However, once the real GDP per capita graphs are adjusted for the significant differences among
rich and poor countries, the outlook isn’t nearly as bleak. Examples include China, India and
Uganda.
A useful way to start thinking about long-run growth is to look at what determines our potential
GDP in any given period. Real GDP depends on the amount of output the average worker can
produce in an hour, the number of hours the average worker spends at the job, the fraction of the
population that wants to work, and the size of the population.
Ultimately, growth in real GDP—by itself—does not guarantee a rising standard of living. What
matters for the standard of living is real GDP per capita—our total output of goods and services
per person. To explain growth in output per person and living standards in the U.S. and other
developed nations, economists look at two factors: increases in labor force participation rates and
growth in productivity. Over the long run, the labor force participation rate rises when
employment grows at a faster rate than the population.
Growth in employment occurs when the demand for labor or the supply of labor increases.
Government policies can help to increase employment. Income tax rate reductions and reductions
in government transfer payments are policies that increase the supply of labor. Policies that help
increase the skills of the work force (such as education and training subsidies) and policies that
subsidize employment directly (such as wage subsidies) increase the demand for labor.
Population growth, growth in average hours, and increases in the labor force participation rate
cannot explain growth in total output—and living standards—over the long run. Over the past
several decades, and into the near future, virtually all growth in the average standard of living
can be attributed to growth in productivity. One key to productivity growth is the nation’s capital
stock. If the capital stock grows faster than employment, then capital per worker will rise, and
labor productivity will increase. But if the capital stock grows more slowly than employment,
then capital per worker will fall, and labor productivity will fall as well.
A government seeking to spur investment—and thereby increase the growth rate of the capital
stock—can direct its efforts toward businesses, toward the household sector, or toward its own
budget. Reducing business taxes or providing specific investment incentives can shift the
investment curve rightward. Policies that alter the tax and transfer system can increase incentives
for saving. This makes more funds available for investment, speeding growth in the capital stock.
Finally, a shrinking deficit tends to reduce interest rates and increase investment, although
shrinking the deficit by cutting government investment will not stimulate growth as much as
would cutting spending that does not contribute to capital formation.
An increase in human capital—like an increase in physical capital—works to increase the
average standard of living by shifting the production function upward, raising productivity. Some
of the same policies that increase investment in physical capital also work to raise investment in
human capital. Additionally, income tax reductions can increase the profitability of human
capital to households, and increase the rate of investment in human capital.
New technology also shifts the production function upward, since it enables any given number of
workers to produce more output. The faster the rate of technological change, the greater the
growth rate of productivity, and the faster the rise in living standards. Policies that increase
research and development spending (such as patent protection, direct government spending, and
tax incentives, as well as policies that stimulate investment spending in general) will increase the
rate of technological change.
Catch-up growth with sustained increases in productivity and living standards occurs when
countries start with very low capital per worker and often is the result of the adaptation of
technologies already in use in richer countries. Government policies can also assist in catch-up
growth. China is a good example of said growth and its case is discussed specifically.
Every measure that promotes economic growth has an opportunity cost. The costs of growth
include budgetary costs, consumption costs, the opportunity costs of workers’ time, and the
sacrifice of other social goals. Growth, like other desirable goals, involves a policy tradeoff.
Some less-developed countries (LDCs) have had great difficulty raising living standards. Much of
the explanation for these low growth rates lies with three characteristics that they share: very low
current output per capita, high population growth rates, and poor infrastructure. These three
characteristics interact to create a vicious circle of continuing poverty. The poorest LDCs are too
poor to take advantage of the tradeoff between consumption and capital production in order to
increase their living standards. Policies that can help break this circle of poverty include a forced
reallocation of resources towards capital production, an increase in sacrificed consumption by the
wealthy, an increase in foreign investment or foreign assistance, and a reduction in the population
growth rate.
DEFINITIONS
In order presented in chapter.
Labor productivity: The output produced by the average worker in an hour.
Growth equation: An equation showing the percentage growth rate of real GDP per capita as the
sum of the growth rates of productivity, average hours, and the employment-population ratio.
Capital per worker: The total capital stock divided by total employment.
Corporate profits tax: A tax on the profits earned by corporations.
Investment tax credit: A reduction in taxes for firms that invest in new capital.
Capital gains tax: A tax on profits earned when a financial asset is sold at more than its
acquisition price.
Consumption tax: A tax on the part of their income that households spend.
Technological change: The invention and use of new inputs, new outputs, or new production
methods.
Discovery-based growth: Economic growth, primarily in advanced countries, based on
technological change from new discoveries.
Catch-up growth: Economic growth, primarily in less-advanced countries, based on increasing
capital per worker from low levels, and adopting technologies already used in more advanced
countries.
Supply-side effect: Macroeconomic policy effects on total output that work by changing the
quantities of resources available.
TEACHING TIPS
1 Motivate students by pointing out the vast discrepancy in per capita income between rich and
poor countries. Ask students why they think these differences exist.
19. It is helpful to write the production function as
Q = A f(K,L)
where A is the level of technology, K is capital, and L is labor. This is consistent with the
chapter’s discussion, but it helps to focus on the issue. Anything that helps increase the
growth of K or L, or that improves technology, will lead to higher economic growth.
Discuss whether capital accumulation can occur without property rights to emphasize the
fact that sociopolitical factors indirectly influence growth.
20. Discuss whether public capital (sewers, roads, hospitals, schools, etc.) can be considered
an important factor of production like private capital. Consider the issues of
substitutability and complementariness between public and private capital (e.g., private
toll roads and public roads are substitutes, while publicly funded education and privately
purchased computers would likely be complementary). See David Alan Aschauer, “Is
Public Expenditure Productive?” Journal of Monetary Economics, March 1989, pp.
177–200.
21. Have students examine the current government budget (they can find it online by going to
www.gpo.gov and searching for “budget”) to find a budget item that could be cut to
reduce the deficit without affecting capital formation. Find a budget item that would lead
to reduced capital formation if it were cut.
22. See http://www.house.gov/jec/news/FiscalConsolidtion.pdf for a look at literature
written by the Republican staff of the Joint Economic Committee advocating capital
gains tax cuts, warning of higher deficits, etc.
DISCUSSION STARTERS
1 The idea that lower income tax rates can increase the supply of labor, as people would enjoy a
higher take-home wage rate, led economist Arthur Laffer to speculate that lower income tax rates
could actually lead to higher tax revenues. This would happen if the taxes paid by newly
employed individuals more than offset the lost tax revenue from the lower tax rate on previously
employed individuals. (Lower tax rates were also supposed to raise tax revenues by reducing tax
cheating.) Illustrate this idea with a Laffer curve, showing tax rates on the vertical axis and tax
revenues on the horizontal axis.
23. Ask students where on this curve Arthur Laffer and President Reagan thought our
economy was in the early 1980s when they advocated cutting tax rates to raise tax
revenues.
24. To show that knowledge of our economy’s location on the Laffer curve is important,
compare the effects of income tax cuts when the economy is on the upward-sloping
portion of the curve (e.g., point A) with the effects when the economy is on the
downward-sloping portion of the curve (e.g., point B).
25. Discuss the effects of government regulations to protect workers, consumers, and the
environment on capital formation rates. The Occupational Safety and Health
Administration protects employees by setting and enforcing workplace safety standards.
The Environmental Protection Agency protects our environment by regulating toxic
waste disposal and automobile emissions. The Food and Drug Administration works to
ensure the safety of our food by setting and enforcing adulteration levels, and the safety
of drugs by requiring rigorous testing on safety and effectiveness.
Do government regulations reduce capital formation rates and/or reallocate expenditures
to different types of capital? What effect might this have on GDP growth? What effect
might this have on our quality of life (as consumers, workers, and citizens of this planet)?
For instance, the Toxic Substances Control Act of 1976, enforced by the Environmental
Protection Agency, can require chemical producers to run tests on new chemicals for
toxicity and other effects. Based on the results of these tests, the EPA can require special
labels for the chemicals, or can restrict or ban their use.
26. China is one country that is trying to reduce its fertility rate in an effort to boost living
standards. Discuss the implications of its one-child-per-family policy on GDP growth.
For information see “Chinese demographics: 6.3 brides for 7 brothers,” The Economist,
December 19,1998, pp. 56–58, or Celia W. Dugger, “Modern Asia’s Anomaly: The Girls
Who Don’t Get Born,” The New York Times, May 6, 2001.