Chapter 12

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Chapter 12Economic Growth
ECONOMICS EXPLORE APPLYby Ayers and Collinge
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Learning Objectives

1. Identify the sources of economic growth.
2. Describe the role of savings and investment in
   the process of capital formation.
3. Analyze how taxation affects both savings and
   investment activity.
4. Provide justification for subsidized higher
   education.

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Learning Objectives

1. Summarize new growth theory and supply side
   economics
2. Discuss the key role of labor productivity in
   economic growth.

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12.1THE SEEDS OF ECONOMICS GROWTH

• Economic growth is measured by the change in real
  GDP over time.
• Sometimes a GNP measure is used instead.
• Economies turn resources into outputs of greater
  value.
• Over time the possibilities for doing so expand
  as the economy develops new technologies, and
  acquires new resources.

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Sources of Economic Growth

• Most U.S. economic growth is attributable to
  increases in labor and capital.
• Both technological change and additional capital
  increase labor productivity.
• Increases in labor productivity means that more
  GDP is produced for each hour worked by by the
  labor force.

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Annualized Growth Rates by Presidency
PRESIDENCY YEARS GROWTH RATE
Kennedy-Johnson 1961-1968 4.9
Nixon-Ford 1969-1976 3.0
Carter 1977-1980 2.7
Reagan 1981-1988 3.5
Bush 1 1989-1992 1.7
Clinton 1993-1999 3.7
Bush 2 2001-2002(1) 2.5
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Sources of Economic Growth

• The growth rate increases in some years,
  decreases in some years, and even falls in other
  years because of economic slowdowns.
• When recession begins, labor productivity tends
  to fall as aggregate demand and production
  decrease.
• When recession nears it end, production at first
  increases, with no corresponding increase in
  employment, causing productivity to rise.

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Sources of Economic Growth

• Labor productivity is associated with the amount
  of capital both physical and human labor has
  at its disposal.
• The creation and accumulation of new capital is
  termed capital formation.
• Capital formation requires initiative, and in
  market economies entrepreneurs make these choices
  based on profitability judgments.

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Nurturing Growth Savings and Investment

• Capital formation requires investment, which can
  be coordinated centrally through government.
• Investment can also be a decentralized process
  that responds to supply and demand in the
  marketplace.
• Investors finance the capital formation that is
  necessary to take advantage of market
  opportunities.

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Nurturing Growth Savings and Investment

• Expand their scale of operations.
• Implement better production techniques.
• Produce new goods that their old factories are
  ill-suited to manufacture.

• Firms invest when they wish to do any of the
  following

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Nurturing Growth Savings and Investment

• To acquire human capital, individuals invest in
  themselves.
• Savings provides the capital for investment.
• Government reduces private savings and investment
  in two ways.
• It taxes away income that might be saved.
• It taxes the return on investments.
• In contrast, government also adds to investment.

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Nurturing Growth Savings and Investment
Without government, aggregate savings and
investment would be the same. With government the
situation is more complex because tax dollars
can be directed towards government investment or
government consumption.
Investment Government consumption Savings
Taxation
or, equivalently,
Investment Savings Taxation - Government
consumption
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Nurturing Growth Savings and Investment

• Higher interest rates raise the cost of
  investing.
• A crowding out effect occurs when government
  borrowing is in competition with private-sector
  borrowing, and thus can cause higher interest
  rates.
• Higher interest rates decrease investment.

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Nurturing Growth Savings and Investment

• Investment is also affected by the following
  factors..
• Business confidence
• Current economic growth
• Opportunities presented by technological change

• Increases in any of these variables would shift
  the investment demand curve to the right.
• Decreases would shift the investment demand curve
  to the left.

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The Equilibrium Interest Rate
Real Interest Rate
Savings and investments
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12.2 INFLUENCING GROWTH THROUGH PUBLIC POLICY

• Private investors assess the expected return,
  which is the value of the investment if
  successful, multiplied by the probability of
  success.
• The actual return can be viewed as ex post,
  meaning after the fact.
• Ex post, an investment might have turned out
  fabulously, or might have failed miserably.

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The Incentive Effects of Taxation

• In addition to regulation, taxes can also affect
  growth.
• A tax on savings increases the market interest
  rate and discourages investment.
• Taxing the return to savings shifts the supply of
  savings to the left.
• There is concern over the low personal savings
  rate in the U.S. in recent years.

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The Incentive Effects of Taxation

• Investment is also discouraged by other taxes
  such as the tax on capital gains.
• Capital gains represents the difference between
  the current market value of an investment and its
  purchase price.
• The capital gains tax takes a percentage of this
  difference when the investment is sold.

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Effects of the Income Tax
Real Interest Rate
Supply of savings
Demand for investment
Savings and investment
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Subsidizing Research and Development

• An external benefit occurs when some benefits are
  received by third parties who are not directly
  involved in a decision, such as the decision to
  research or invest.
• Research is aimed at creating new products or
  otherwise expands the frontiers of knowledge and
  technology.
• Development occurs when that technology is
  embodied into capital or output.

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Subsidizing Research and Development

• External benefits are most prominent at the
  research stage.
• Especially when the research involves the
  creation of knowledge that can be applied to the
  production of many different products.
• It is difficult for any one investor or group of
  investors to assert property rights over the
  range of applications that can arise from basic
  advances in knowledge.
• To correct this market failure the government
  subsidizes research.

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Subsidizing Research and Development
Universities are often the source of valuable
research, subsidized by government that
companies fear to undertake on their own.
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12.3PROPERTY RIGHTS AND NEW GROWTH THEORY

• The prospect for business profits in the future
  can lead to research and development in the
  present.
• This idea is the cornerstone for what is called
  the new growth theory, which emphasizes the
  importance of new ideas in generating economic
  growth, and intellectual property rights in
  providing the profit incentive to generate those
  ideas.

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12.4SUPPLY-SIDE POLICY

• Those economist who particularly emphasize policy
  aimed at growth are called supply-side
  economist, or supply-siders for short.
• Supply-siders focus on increasing the value of
  what the economy can produce in the long-run (the
  supply side) rather than on any desire to change
  consumers spending behavior (the demand side).
• Supply-siders feel that the short-run business
  cycle will sort itself out over time as long as
  the government does not intrude.

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Supply-Side Policy

• The objective of supply-side policy is to ensure
  that output associated with full employment is as
  high as possible.
• Supply-side policies are designed to increase
  productivity, such as through increasing capital
  formation.
• Full-employment output will change in response to
  changes in structural features of the economy,
  including resources and technology.
• Structural features also include government
  policies that change how workers and firms behave.

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Supply-Side Policy
Critics refer to supply-side policies as trickle
down economics. The term suggest that the
policies were intended to make the rich richer,
so that they might spend a bit more and help the
rest of us. This is not the process intended by
supply-siders, instead they aim at increasing
productivity, not spending.
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Supply-Side Policy
Long-run Aggregate supply
Price level
Real GDP
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The Laffer Curve

• Increasing tax rates will increase tax revenues,
  but only up to a point.
• After that point, higher tax rates are
  self-defeating and actually reduce tax revenues.
• At a rate of 100 percent, there would be no point
  to earning any income at all.

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The Laffer Curve
Tax Revenue
Maximum Tax Revenue
0
Tax rate
100
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How Technology Impacts Growth

• The new U.S. economy is characterized by the
  application of technology to increase business
  productivity.
• The growth of computers in the workplace
  increases the productivity of labor.
• Throughout history, the economy has been
  revitalized again and again by technologies like
  the railroad, the automobile, radio, television,
  and now the computer and the Internet.

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Sources of Changes in United States Labor
Productivity 1979-2000
Item 1970 to 1990 1990 to 1995 1995 to 2000
(1) Output per hour (labor productivity) 1.6 1.5 2.7
(2) Contribution of capital 0.8 0.5 1.1
(2a)Contribution of information technology capital 0.5 0.4 0.9
(2b) Contribution of other capital 0.3 0.1 0.2
(3) Contribution of labor 0.3 0.4 0.3
(4) Contribution of technological change and other factors 0.5 0.6 1.4
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12.5 EXPLORE APPLYThe New Economy Is It Real?

• In the 1990s the new economy was characterized
  by the tremendous wealth creation in the Silicon
  Valley.
• The new economy is characterized by the
  application of technology to increase business
  productivity.
• The application of computer technology has been
  especially significant.

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Terms Along the Way

• economic growth
• labor productivity
• capital formation
• crowding-out effect
• expected return
• actual return
• capital gains

• capital gains tax
• external benefit
• research
• development
• property rights
• new-growth theory
• supply-side economists

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Test Yourself

• Technological change and additional capital
• increase labor productivity.
• decrease labor productivity.
• have no effect on labor productivity.
• affect labor productivity in unpredictable ways.

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Test Yourself

• 2. U.S. economic growth
• has generally been characterized by a 5 percent
  or more growth rate since the 1960s.
• varied with each president.
• was on a downward trend in the 1990s, but has
  recently reversed its course.
• is no longer considered an important goal.

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Test Yourself

• 3. Capital formation is also referred to as
• property rights.
• technology .
• the real interest rate.
• investment.

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Test Yourself

• 4. Investment equals
• savings taxation.
• savings taxation.
• savings taxation government consumption.
• savings taxation government consumption.

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Test Yourself

• 5. Higher real interest rates
• increase the amount of investment.
• decrease the amount of investment.
• have no effect on the amount of investment.
• have varying and unpredictable effects on
  investment.

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Test Yourself

• 6. The Laffer curve shows that the effect of
  increasing taxes too much is
• less economic growth.
• less tax revenue.
• more unemployment.
• that only the rich get richer.

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The End! Next Chapter 13 Money, Banking, and the
Federal Reserve"