Lecture Outlines - Week 10

Economic Growth (Ch. 15 of Schiller)

Economic growth is defined as increases in real GDP.

Economic growth can occur by more fully utilizing existing capacity (moving from being inside to being on the PPF), such as when an economy grows out of a recession, or by increasing capacity (shifting the PPF outwards).

Since the time of Keynes, short-run macroeconomic policy has been focused on dampening the highs and lows of the business cycle through adjustments to aggregate demand.

For an economy to experience long-term growth, however, the aggregate supply curve must shift outwards.

Measuring Economic Growth

We can measure the growth rate in real GDP as follows:

Annual growth rate in real GDP = [(real GDP this year)-(real GDP last year)]/(real GDP last year) x 100

Annual growth rate in real GDP, year 2000: ((GDP₀₀ - GDP₉₉)/(GDP₉₉)) * 100

We can measure real GDP per capita as follows:

Real GDP per capita = (real GDP)/population

Note: During the 1990s the economic growth rate of 3 percent exceeded the population growth rate of 1 percent, and thus real GDP per capita increased. Does that mean that the average worker's real income increased? Why or why not?

The Sources of Economic Growth

Since Adam Smith's time, it has been apparent that economic growth and material wealth is created and maintained by productive factors of production -- land, labor, and capital.

Thus economic growth is caused by one or more of the following:

• Increasingly skilled and productive workforce: Indicated by higher levels of output per hour of labor; requires investment in education and training, as well as adequate compensation.
• Increases level of capital: Indicated by higher capital/labor ratio; requires investment in new and more productive capital, and an internal return on capital that is sufficient to make such an investment profitable.
• Improved management of firms.
• Technological advance: Indicated by "better, faster, and cheaper" products and services; requires investment in research by private industry and government, and an internal return on investment to justify the expenditures.

Thus investment is required in order to generate productivity gains, which in turn is necessary for economic growth. There is a strong relationship between levels of investment and rates of economic growth.

What is the opportunity cost of investment? Why might it be higher for a wealthy country than for a less wealthy country?

Growth Policy

1. Funding and promotion of education and training. K-12 and beyond. Not just skills but attitudes and discipline and self-confidence.
2. Subsidy or reduced taxation on investment by people (training and ed) and business (capital investment). Both get special tax treatment, though it took a long time for education investment to be treated like business capital investment.
3. Stable and efficient regulatory environment: Regulate where needed; minimize the cost of achieving a desired outcome such as workplace safety, health, or environmental protection.
4. Promote savings: Examples would be favored tax treatment for IRA's.
5. Social stability: Promote "buy-in" to the system by taking efforts to reduce income inequality and discrimination. Lack of social stability will ultimately undermine economic growth.
6. Reduce national debt as a percentage of GDP: High budget deficits crowd out private investment. Why? Because when there is a large national debt, the government must borrow a lot of money by issuing bonds, and the government's demand for borrowed funds tends to raise interest rates and reduce the amount of loanable funds available for private borrowing for investment in human or created capital.
7. Maintain quality public infrastructure: Government needs adequate funds to maintain valuable public goods such as public schools, roads, bridges, water treatment, public health, etc. Economic growth occurs in the context of quality public goods that cannot be neglected.

Is Growth Desirable?

Not all economic growth is necessarily desirable. In very poor countries where most people live in abject poverty in shantytowns outside of places like Mexico City, Rio de Janeiro, Cairo, etc., higher income is needed for basic human needs such as sanitation, nutritious food, and shelter. These folks make a strong case for economic growth.

In extremely wealthy countries economic growth has contributed to what some consider to be excessive greed, a wanton materialistic secular consumer society, that has undermined community structures, promoted sprawl, and squandered our natural heritage.

Can we reduce the material nature of economic growth so that we reduce the negative impacts? Can we select a mix of goods and services that help promote a more sustainable society?

This question falls under the topic of the economics of sustainability. If you have an interest in this question, consider taking Economics 309, The Economics of a Sustainable Society, offered in the spring.

Does per-capita real GDP adequately and completely measure well-being?

GDP simply tallies up the value of market transactions, yet traditional macroeconomic performance defines the issues that policy makers work to address. If traditional macroeconomics does not tell the whole story, then policy makers are working off of flawed or incomplete data.

Examples of some limitations of using real per-capita GDP as an indicator of well-being:

• Money spent deterring and remediating crime and other problems associated with the deterioration of communities is counted as economic gain and increases in GDP, as is money spent after a natural disaster.
• Money spent remediating pollution problems is added to the income generated by the industrial process that originally created the pollution problem, thus creating the illusion that the industrial activity creates a double benefit to society.
• GDP is not affected by the degree of inequality in the distribution of income in a national economy.
• GDP does not take into account moral, spiritual, or aesthetic values associated with biodiversity, wilderness, Native American religious sites, or unique aspects of the natural environment.
• GDP does not distinguish between a dollar generated by sustainable harvest of a resource from a dollar generated in the process of exhausting a natural resource.
• Simple GDP accounting treats every transaction as positive, as long as money changes hands. Besides the above mentioned limitations, GDP does not take into account valuable services provided for free. For example:
• GDP does not take into account unpaid housework -- child rearing, cooking, cleaning, family support, etc.
• GDP does not take into account the value of volunteer work.

Thus simple GDP accounting treats every transaction as positive, as long as money changes hands, and therefore real per-capita GDP is inadequate as an indicator of progress toward a sustainable society. Lets now look beyond GDP to find indicators of weak- and strong-form sustainability.

Are there alternatives to national income accounting?

There are several alternatives to national income accounting that have been proposed. Alternative systems include the Green GDP, the Index of Sustainable Economic Welfare (ISEW) and the Genuine Progress Indicator (GPI). All of these alternatives include measures of the health of the environment and the existence of community.

Example: To compute the GPI, one starts with real personal consumption spending, adjusts for income distribution, and then adds or subtracts a number of different elements that reflect ecological and social benefits or costs.

Adjustment factors added to traditional consumption spending to arrive at the GPI include

• The value of household work and parenting, based on the cost of hiring out these services, based on the work of economist Robert Eisner
• The value of volunteer work, using Census Bureau data and taking the opportunity cost of time at $8 per hour
• Services of consumer durables net of their costs (from making do with old things)
• Services of government capital such as highways, streets, and other infrastructure, as a percentage of the total value of the stock of these assets

Factors subtracted from traditional consumption spending to arrive at GPI include

• Cost of crime
• Cost of family breakdown, based on added expenditures
• Loss of leisure time
• Cost of underemployment, at opportunity cost
• Cost of consumer durables
• Cost of commuting (a defensive expenditure)
• Cost of household pollution abatement
• Cost of automobile accidents
• Cost of water, air, and noise pollution
• Loss of wetlands
• Loss of farmlands
• Depeletion of nonrenewable energy resources
• Other long-term environmental damage
• Cost of ozone depletion
• Loss of old-growth forests

As you might expect, green GDP, genuine savings, ISEW, GPI, and similar weak-form sustainability measures are controversial, particularly among economists. Many economists are uncomfortable with them because they are not as concrete and objective as traditional GDP accounting. For example, the dollar values assigned to GPI elements such as family breakdown and loss of old-growth forests are to some degree subjective and open to debate, while the conventional national income accounting methods underlying GDP are widely accepted. In its description of augmented accounts for tracking economic sustainability the National Research Council (1999) excludes elements such as income inequality and the success and happiness of families. While both of these are included in the ISEW and the GPI, and in fact inequality is a major factor explaining their trend, the National Research Council argued that that such things are important but not amenable to economic measurement. And finally, despite the complexity of measures such as the ISEW and the GPI, they still exclude important factors such as risk and uncertainty. Should the path to sustainability be risk-free, or is society willing to accept policies or technologies that offer a good chance of a major improvement, but at the cost of a small chance of a loss in sustainability?

While alternative measures are clearly controversial and somewhat subjective, it is also clear that current GDP accounting offers a highly incomplete view of economic wellbeing and sustainability. There is a growing recognition of the need for augmenting the traditional national income and product accounts. For example, the National Research Council (1999) observes that "augmented national income accounts would ... be valuable as indicators of whether economic activity is sustainable.... It is clear that the national productivity depends on many nonmarket elements, including not only the environment, but such things as schooling, health care, and social capital in volunteer and civic organizations. It may not be possible to capture all these important facets of modern society in nation's accounts, but an attempt should surely be made..." (p. 15-16).