Economic Growth - Complete

Economic growth occurs when a society produces more goods and services than in the previous time period. It is typically measured as the percentage change in gross domestic product (GDP) or a similar measure (such as real GDP or per capita GDP). The primary benefit of economic growth is that increases in output may allow more of society´s needs and wants for material possessions to be satisfied.

Objectives

After studying this chapter, you should be able to:
· define macroeconomics and macroeconomic policy.
· list the three primary goals of macroeconomic policy.
· list the two primary tools of macroeconomic policy.
· define monetary policy and fiscal policy.
· define and explain the relationship between standard of living and economic growth.
· define gross domestic product (GDP), which is also called nominal GDP or money GDP.
· define and explain the difference between final products and intermediate products.
· explain why economic growth is important, from an historical perspective and a geographical perspective.
· state how U.S. GDP compares to other countries in the world. (U.S. GDP is larger.)
· define per capita GDP, explain how it is calculated, and explain why it is a better measure of standard of living than GDP.
· state how U.S. per capita GDP compares to other countries in the world. (Luxembourg is the only country with a higher per capita GDP.)
· state the equation that relates the present and future values of GDP based on the growth rate and the number of years and use it to calculate economic growth.
· calculate the future value of gross domestic product (GDP) from the present value, rate of growth, and number of years.
· state the rule of 70 and use it to approximate the amount of time it takes for an economy’s GDP to double.
· list and explain the sources of economic growth.
· define productivity, physical capital, human capital, and technology.
· list and explain the composition of GDP based on the types of goods and services produced.
· define durable goods, non-durable goods, services, and structures.
· list and explain the composition of GDP based on the purchaser of the newly produced goods and services.
· define consumption, investment, government purchases, transfer payments, exports, imports, and net exports.
· define gross national product (GNP) and explain how it differs from GDP.
· define real GDP and explain its relationship to nominal GDP and the inflation rate.
· define base year.
· define per capita real GDP and explain how it is calculated
· calculate nominal GDP from a table of prices and outputs of one or more products from one or more years.
· calculate real GDP from a table of prices and outputs of one or more products from one or more years.
· list and explain at least five criticisms of using GDP as a measure of economic welfare.
· explain how the government can use monetary policy to promote economic growth.
· explain how the government can use fiscal policy to promote economic growth.


Macroeconomic Policy

Macroeconomics studies issues of resource allocation that affect the entire economy, such as economic growth, unemployment, and inflation.

Macroeconomic policy refers to the government’s attempts to influence the whole economy.

The economy can be compared to a bus traveling down the highway. The government is the bus driver for the economy, trying to keep it on the road to prosperity. The government can cause the economy to speed up, slow down, stop, or even go backwards. The economy can be driven off the road and crash, or it can be kept traveling comfortably forward. It is possible to go too fast or too slow, to run over other things, to scare the passengers or make them carsick. Since people never seem to satisfy all their needs and wants, we stay on the bus and hope it will take us to greater wealth and prosperity, with as much comfort and little inconvenience as possible.


Macroeconomic Policy Goals and Tools

There are three primary macroeconomic policy goals: economic growth, low unemployment, and low inflation.

There are two primary macroeconomic policy tools that are used to achieve these goals: monetary policy and fiscal policy. Monetary policy is the Federal Reserve System’s use of the money supply, interest rates, and the banking system to influence the economy. Monetary policy is the most commonly used tool of macroeconomic policy. Fiscal policy is taxing and spending by the government. Fiscal policy has a political bias and is difficult to use when the economy needs a reduction in overall spending.

The Measurement of Economic Growth

Standard of living is the value of the goods and services available to an individual, group, or country. For example, the average person in the United States has a higher standard of living than the average person in Ethiopia. The average person in the United States has plenty of food and clothing, a decent place to live, a car, a television, and many other luxuries. The average person in Ethiopia, however, has none of these things.

Economic growth attempts to measure changes in a country’s standard of living by measuring the rate at which the country’s output changes. Since people tend to be paid based on their productivity, the value of a country’s output is also the value of the country’s income. For example, if a baker makes 20 cakes in a day and sells them for $10 each, the value of the baker’s productive output that day is $200. Since the baker was paid $200 for the cakes, the baker’s income that day is also $200. Since income is equal to the value of output, economic growth also measures how people’s incomes are changing.

The most common way to measure economic growth is by examining changes in gross domestic product. Gross domestic product (GDP) is the total value of all final goods and services produced in a country during a given period (usually a year). Final products are goods and services that are not used to make other products. They are distinguished from intermediate products, which are inputs in the production of other goods and services. For example, some farmers in the United States grow wheat. Some of that wheat is used to make flour. Some of that flour is used to make bread. In this example, bread is a final product. The wheat and flour used to make the bread are intermediate products. Gross domestic product only measures the value of final products to avoid counting the same productive output more than once. The value of the bread includes the value of the flour used to make the bread. If GDP counted the value of the bread and the value of the flour, then the flour used to make the bread would be counted more than once.

GDP is sometimes referred to as nominal GDP or money GDP because it values the output of a particular year using prices from that year. For example, it measures 2003 output using 2003 prices and measures output in 2002 using the prices from 2002. The U.S. gross domestic product in 2003 was $11.003 trillion. U.S. GDP in 2002 was $10.487 trillion. The percentage change in U.S. GDP between 2002 and 2003, which measures economic growth, was 4.92%.


The Importance of Economic Growth – from an historical perspective

The Time Machine: An Invention, by H.G. Wells, was published in 1898. In this novel, a scientist builds a machine that allows him to travel into the past or future. If you could travel back to the end of the 19th century, would you do it? Would you prefer to live in the United States in 1900 rather than now? Consider the following facts about the U.S. in 1900[1]:

· The average life expectancy in the United States was forty-seven.
· Only 14 percent of the homes in the Unites States had a bathtub.
· Only 8 percent of the homes had a telephone. A three-minute call from Denver to New York City cost eleven dollars.
· The average wage in the U.S. was twenty-two cents per hour. The average U.S. worker earned between $200 and $400 per year.
· A competent accountant could expect to earn $2000 per year, a dentist $2500 per year, a veterinarian between $1500 and $4000 per year, and a mechanical engineer about $5000 per year.
· There were only 8,000 cars in the U.S. and only 144 miles of paved roads.
· The maximum speed limit in most cities was ten miles per hour.
· Alabama, Mississippi, Iowa, and Tennessee were each more heavily populated than California. With a mere 1.4 million residents, California was only the twenty-first most populous state in the Union.
· The tallest structure in the world was the Eiffel Tower.
· More than 95 percent of all births in the United States took place at home.
· Ninety percent of all U.S. physicians had no college education. Instead, they attended medical schools, many of which were condemned in the press and by the government as “substandard.”
· Sugar cost four cents a pound. Eggs were fourteen cents a dozen. Coffee cost fifteen cents a pound.
· Most women only washed their hair once a month and used borax or egg yolks for shampoo.
· Canada passed a law prohibiting poor people from entering the country for any reason, either as travelers or immigrants.
· The five leading causes of death in the U.S. were:
1. Pneumonia and influenza
2. Tuberculosis
3. Diarrhea
4. Heart disease
5. Stroke
· The American flag had 45 stars. Arizona, Oklahoma, New Mexico, Hawaii and Alaska had not been admitted to the Union yet.
· Drive-by shootings – in which teenage boys galloped down the street on horses and randomly shot at houses, carriages, or anything else that caught their fancy – were an ongoing problem in Denver and other cities in the West.
· The population of Las Vegas, Nevada, was thirty. The remote desert community was inhabited by only a handful of ranchers and their families.
· Plutonium, insulin, and antibiotics had not been discovered yet. Scotch tape, crossword puzzles, canned beer, and iced tea had not been invented yet.
· There was no Mother’s Day or Father’s Day.
· One in ten U.S. adults could not read or write. Only six percent of all Americans had graduated from high school.
· Marijuana, heroin, and morphine were available over the counter at corner drugstores. According to one pharmacist, “Heroin clears the complexion, gives buoyancy to the mind, regulates the stomach and the bowels, and is, in fact, a perfect guardian of health.”
· Coca-Cola contained cocaine instead of caffeine.
· Punch card data processing had recently been developed, and early predecessors of the modern computer were used for the first time by the government to help compile the 1900 census.
· Eighteen percent of households in the United States had at least one full-time servant or domestic.
· There were about 230 reported murders in the U.S. annually.


Most people would prefer to live in the present day. Life in 1900 was extremely hard. This point was vividly illustrated in a PBS television series entitled The 1900 House. PBS describes the series as:

a new four-part documentary that "transports" an actual modern family from 1999 back to life in 1900. Public television viewers will have the chance to vicariously experience a time-travel journey back to everyday, middle-class life in Victorian London. The adventurous Bowler Family spent three months living in a townhouse carefully restored to reproduce the ambiance and amenities of the turn of the century. As a result, THE 1900 HOUSE explores the radical changes in family and domestic life that have occurred over the past 100 years through scientific and technological innovations.[2]

Economic growth generally creates an improved standard of living over time. Most people have more material possessions than their grandparents (or even their parents) had at their same age.




Sources of Economic Growth

One way for an economy to produce more output is to obtain more resources. Even with the same resources, however, it is possible for an economy to produce more output if workers become more productive. Productivity is the quantity of goods and services produced from a typical hour of a worker’s labor. Improvements in productivity allow an economy to produce more output and thus earn more income. This increased income represents an improved standard of living. Thus an increased standard of living usually depends on increasing a country’s productivity. Thus, improved productivity is the key to economic growth.

Increases in productivity fall into three categories:

1. Investment in physical capital – “Build more machines.”
2. Investment in human capital (education and skills) – “Make workers more productive.”
3. Investment in technology – “Build more productive machines.”


Investment in physical capital

Physical capital is anything man-made that makes labor more productive. Fiscal policies to increase investment in physical capital include direct government spending on infrastructure (e.g., roads, bridges, hospitals) and tax incentives to encourage private businesses to invest (e.g., new factories or machinery). Monetary policies that achieve low interest rates also encourage businesses to invest more in physical capital by decreasing its opportunity cost.


Investment in human capital

Human capital is the education, training, and skills people acquire that makes them more productive. Fiscal policies to increase investment in human capital include direct government spending on education and job training or tax incentives to encourage education and skills training. Monetary polices that keep interest rates low may also make it easier for people to acquire more education by lowering the cost of loans to pay tuition and other expenses.


Investment in technology

Technological innovations usually create increases in productivity. For example, scientists have developed agricultural crops that are more disease-resistant and have thus increased the yields from our farmland. Fiscal policies that promote investment in technology include direct government spending on research and development [e.g., National Science Foundation (NSF) grants] and tax incentives to encourage private businesses to invest in discovering new technologies. Monetary policies that keep interest rates low also encourage businesses to invest in technology by decreasing the cost of borrowing money.


A Closer Look at the Measurement of Economic Growth

The Composition of GDP

Gross domestic product can be broken down into several categories based on the type of goods and services produced. For example, the output of the country can be divided into durable goods, non-durable goods, services, and structures.

GDP = durable goods + non-durable goods + services + structures

Durable goods are products that are used over a long period of time. Refrigerators, washing machines, and cars are examples of durable goods. Non-durable goods are products that are consumed over a short period of time. Food and clothing are examples of non-durable goods. Services are products that typically do not create a tangible commodity. Banking services, haircuts, and entertainment are examples of services. Structures are buildings. Over half of U.S. GDP is services.

Durable goods orders are sometimes used as an indicator of the health of the U.S. economy.

Gross domestic product also can be broken down into several categories based on the purchaser of the newly produced goods and services. This alternative way to divide GDP involves separating it into consumption spending, investment spending, government purchases, exports, and imports.

An equation that illustrates this relationship is:

GDP = C + I + G + X - M
where:
C = consumption spending
I = investment spending
G = government purchases
X = exports
M = imports

Consumption is the purchase of final goods and services by households. Investment is the purchase of capital equipment, inventories, and structures. Most of this is done by businesses. The purchase of a home by a household, however, is also considered to be investment.
Government purchases are payments made in exchange for currently produced goods and services. This includes salaries of current government workers, vehicles purchased for government use, and supplies for government offices. Government purchases do not include transfer payments. A transfer payment is a government payment not made in exchange for a good or service. Social Security benefits, retirement checks paid to former government employees, and welfare benefits are examples of transfer payments. Exports are goods and services sold by domestic producers to foreign purchasers. For example, a jet fighter manufactured in the U.S. and purchased by the government of Egypt is an exported good. Imports are goods and services sold by foreign producers to domestic purchasers. The domestic purchasers might by households, businesses, or the government. For example, a Mercedes-Benz automobile manufactured in Germany and sold to an American consumer is an imported good.

The difference between exports and imports (X – M) is referred to as net exports (NE). Thus an alternative way to write the equation for gross domestic product is:

GDP = C + I + G + NE


Gross National Product

Another measure of a country’s output is gross national product. Gross national product (GNP) is the total value of all final goods and services produced in a given period (usually a year) by businesses owned by citizens of a country.

Gross means total. Product means output. Both GDP and GNP measure the total output produced by a country. GDP measures the final output produced in a country, regardless of ownership of the businesses. Thus, the key to GDP is location, not ownership. The key to GNP is ownership, not location. For example, if a Japanese company operates in the United States, the value of its output in the U.S. is included in U.S. GDP and Japanese GNP. Yet, the output of a Japanese company’s operations in the U.S. would not be included in U.S. GNP or Japan’s GDP.

The U.S. Commerce Department used GNP to measure U.S. output from 1900 to 1991. Since then, GDP has been used. Most countries in the world use GDP to measure their output. A few countries in the world still use GNP, however.

Real Gross Domestic Product

Although GDP is the most common measure of a country’s output, it may not be the best measure. Real GDP measures the value of the total final output of a country's economy without the influence of inflation. Inflation is a general increase in the prices in an economy. Real GDP measures the output of a country’s final goods and services in constant dollars (i.e., using prices in a single base year to measure output in different years). (For example, it might measure output in 2003, 2004, and 2005 using prices from 2000.) When calculating real GDP, the base year is the year from which prices are used to calculate the value of output.

Nominal GDP in year x = prices in year x outputs in year x
Real GDP in year x = prices in the base year outputs in year x

A Simple Example of an Economy with One Product

To illustrate the difference between nominal GDP and real GDP, consider a simple economy that only produces one product, widgets. Suppose this economy produces 100 widgets in 2003 and the price of widgets in 2003 is $1. Thus, the economy’s nominal GDP in 2003 is $100. Suppose the economy produces 100 widgets in 2004, but the price of widgets in 2004 is $2. Nominal GDP in 2004 is $200. If one uses nominal GDP to measure output, one might think this economy produced more output in 2004 than 2003 (since nominal GDP in 2004 is larger than nominal GDP in 2003). Yet output in this economy was the same in 2003 and 2004. The reason nominal GDP is larger in 2004 than in 2003 is because the price of widgets increased. Real GDP attempts to measure the real change in output without the influence of inflation. In this simple example, let 2003 be the base year. Thus real GDP in 2003 is calculated by multiplying the quantity of output in 2003 by the price of widgets in 2003 (since 2003 is the base year).

Real GDP in 2003 = $1 100 = $100

Real GDP in 2004 is calculated by multiplying the quantity of output in 2004 by the price of widgets in 2003 (since 2003 is the base year).

Real GDP in 2004 = $1 100 = $100

Since real GDP in 2003 and 2004 is the same, it indicates real output did not change. Thus changes in real GDP are a better measure of changes in real output than changes in nominal GDP.
Per capita real GDP measures the real value of a country’s output per person. It is calculated by dividing real GDP by the country’s population.
Many economists think the single best measure of a country's standard of living is per capita real GDP because it measures the income of an average person in a country without the influence of inflation.

Limitations of Using GDP as a Measure of Quality of Life

Gross domestic product and its related concepts (such as real GDP, per capita GDP, and per capita real GDP) are incomplete measures of a country’s standard of living. There are many productive activities that are not included in GDP because it only measures output produced and sold in legal markets. It does not include productive activity that does not have a market transaction.

Although GDP and its related concepts are useful in measuring a country’s output, income, and standard of living, they are not perfect measures of quality of life. Quality of life refers to the amount of fulfillment people have in life. There are also many aspects of the quality of life that are not considered in the calculation of output, such as leisure, the environment, and the quality of people’s health.

Criticisms of GDP data as measurements of quality of life include:

1. GDP only measures the output produced and sold in legal markets.
It does not include productive activity that does not have a market transaction.

Activities INCLUDED In Gross Domestic Product (GDP)
Activities NOT INCLUDED In Gross Domestic Product (GDP)
Hiring a lawn service to mow your yard.
Mowing the lawn yourself.
Taking your children to a day-care center.
Caring for your children yourself.
Hiring a plumber to fix a water leak at your house.
Fixing the water leak yourself.
Prostitution in Nevada (where it is legal).
Prostitution in the rest of the U.S. (where it is illegal).

2. GDP does not consider how output contributes to the quality of people’s lives.
It simply measures how much output a country produces. For example, people who live in urban areas spend a portion of their incomes on products to help them cope with urban problems. For example, urban residents buy more alarm systems for their homes and cars, self-defense classes, and stress medication. Some economists refer to these products as "bads" rather than "goods".

Suppose you live in a rural area. If you move into the city, you can change to a job that pays you $1000 more per year. Suppose urban life causes you to spend $1000 per year on things you did not need living in a rural environment. Even though your income is larger, has moving to the city improved the quality of your life?
3. GDP does not measure the quality of the environment.
A country might be able to increase its output (and GDP) if it eases pollution regulations. Yet, having higher per capita real GDP might not mean people have a better quality of life if the air, water, and other resources are more polluted.

4. GDP does not consider how leisure contributes to the quality of life.
A country could increase its output (and GDP) if its people worked 12 hours per day, seven days per week. However, having more products might not mean people are better off if they have no leisure time to enjoy it.
Virtually all data have limitations. Even though GDP data are not perfect measures of the quality of life in a country, they are still useful in measuring the standard of living.






IMPORTANT DEFINITIONS FROM CHAPTER 6

Macroeconomics studies issues of resource allocation that affect the entire economy, such as economic growth, unemployment, and inflation.

Macroeconomic policy is the government’s attempts to influence the whole economy.

Macroeconomic policy goals are the objectives the government tries to achieve when it influences the whole economy: economic growth, low unemployment, and low inflation.

Macroeconomic policy tools are the monetary and fiscal policies that can be used to influence the entire economy.

Monetary policy is the Federal Reserve System’s use of the money supply, interest rates, and the banking system to influence the economy. Monetary policy is the most commonly used tool of macroeconomic policy.

Fiscal policy is taxing and spending by the government.

Standard of living is the value of the goods and services available to an individual, group, or country.

Economic growth attempts to measure changes in a country’s standard of living by measuring the rate at which the country’s output changes. Since people tend to be paid based on their productivity, the value of a country’s output is also the value of the country’s income. Since income is equal to the value of output, economic growth also measures how people’s incomes are changing.

Gross domestic product (GDP) is the total value of all final goods and services produced in a country during a given period (usually a year).

Final products are goods and services that are not used to make other products.

Intermediate products are goods and services that are inputs in the production of other goods and services.

Nominal GDP is the total value of all final goods and services produced in a country in a period of time (usually a year). It is another name for gross domestic product (GDP).

Money GDP is the total value of all final goods and services produced in a country in a period of time (usually a year). It is another name for gross domestic product (GDP).

Per capita GDP measures the nominal value of a country’s output per person. It is calculated by dividing nominal GDP by the country’s population. It is a measure of the average income of a person in the country.
Productivity is the quantity of goods and services produced from a typical hour of a worker’s labor.

Physical capital is anything man-made that makes labor more productive.

Human capital is the education, training, and skills people acquire that makes them more productive.

Durable goods are products that are used over a long period of time, such as refrigerators, washing machines, and cars.

Non-durable goods are products that are consumed over a short period of time, such as food and clothing.

Services are products, such as banking services, haircuts, and entertainment, that typically do not create a tangible commodity. Over half of U.S. gross domestic product is services.

Structures are buildings.

Consumption is the purchase of final goods and services by households.

Investment is the purchase of capital equipment, inventories, and structures. Most of this is done by businesses. The purchase of a home by a household, however, is also considered to be investment.

Government purchases are government payments made in exchange for currently produced goods and services. This includes salaries of current government workers, vehicles purchased for government use, and supplies for government offices. Government purchases do not include transfer payments.

A transfer payment is a government payment not made in exchange for a good or service. Examples of transfer payments are Social Security benefits, government pensions, and welfare payments.

An export is a good or service sold by a domestic producer to a foreign purchaser.

An import is a good or service sold by a foreign producer to a domestic purchaser.

· Net exports (NE) are the difference between the value of a country’s exports (X) and imports (M).

Gross national product (GNP) is the total value of all final goods and services produced in a given period of time (usually a year) by businesses owned by citizens of a country.

Real GDP measures the value of the total final output of a country's economy without the influence of inflation.

Inflation is a general increase in the prices in an economy.

Real GDP measures the output of a country’s final goods and services in constant dollars.

The base year is the year from which prices are used to calculate the value of output.

Per capita real GDP measures the real value of a country’s output per person. It is calculated by dividing real GDP by the country’s population.

· Quality of life is to the amount of fulfillment a person has in life.

QUESTIONS FOR FURTHER STUDY

1. Describe the life of a typical American around 1800. How much have the standard of living and quality of life changed over the last 200 years?

2. Are current politicians promoting policies that will lead to increased economic growth? Provide evidence to support your answer. How would you change current public policy to achieve a higher standard of living or quality of life?





ENDNOTES

[1] “When My Grandmother Was a Child,” by Leigh W. Rutledge.

[2] www.pbs.org