10.2 Economic Growth: Basic Relationships

Question 1

What is the difference between equilibrium in the long and short run?

Answer 1

In the short-run macro model, real GDP adjusts to determine equilibrium, in which desired saving equals desired investment. In the model’s long-run version, real GDP is equal to and the real interest rate adjusts to determine equilibrium.

Question 2

What are the three different concepts of saving that we must consider in the presence of a government that spends and collects taxes?

Answer 2

In the presence of government that spends and collects taxes, it is necessary to distinguish between three different concepts of saving—private saving, public saving, and national saving.

Question 3

What is private saving and its formula?

Answer 3

Private saving is the difference between disposable income and desired consumption. With real GDP equal to in the long run, private saving is equal to

Question 4

What is public saving and its formula?

Answer 4

Question 5

What is national saving and its formula?

Answer 5

Question 6

How do we label a graph containing a National Saving curve?

Answer 6

The horizontal axis measures the quantity of national saving (in real terms). The real interest rate is shown on the vertical axis.

Question 7

Why is the NS curve upward sloping?

Answer 7

The national saving (NS) curve is upward sloping because, as we first saw in Chapter 6, an increase in the interest rate is assumed to lead households to reduce their current consumption, especially on big-ticket items such as cars, furniture, and appliances, that are often purchased on credit.

Question 8

Why is the NS curve steep?

Answer 8

Note also that the NS curve is quite steep, in keeping with empirical evidence suggesting that household consumption responds only modestly to changes in the real interest rate.

Question 9

What does a graph of a NS curve look like?

Answer 9

Question 10

What determines the equilibrium real interest rate?

Answer 10

In the long run, the condition that desired national saving equals desired investment determines the equilibrium real interest rate.

Question 11

How is investment demand by firms related to real interest rate?

Answer 11

Investment demand by firms is negatively related to the real interest rate.

Question 12

How is the supply of national (private plus public) saving related to real interest rate?

Answer 12

The supply of national (private plus public) saving is positively related to the real interest rate, since increases in the interest rate lead to a decline in desired consumption (C).

Question 13

How are components of desired investment related to real interest rate?

Answer 13

A downward-sloping investment demand curve, I. As we first saw in Chapter 6, all components of desired investment (plant and equipment, inventories, and residential investment) are negatively related to the real interest rate because, whether the investment is financed by borrowing or by using firms’ retained earnings, the real interest rate reflects the opportunity cost of using these funds.

Question 14

What do the NS and I curve show?

Answer 14

The NS curve shows the supply of financial capital that comes from households and governments.

The I curve shows the demand for financial capital derived from firms’ desired investment in plant, equipment, and residential construction.

The interest rate that clears this market for financial capital determines the amount of investment and saving that occur in the economy’s long-run equilibrium, when real GDP is equal to Y*.

Question 15

In the long-run version of our macro model, what determines equilibrium interest rate?

Answer 15

In the long-run version of our macro model, with real GDP equal to Potential output, the equilibrium interest rate is determined where desired national saving equals desired investment.

i* Where NS = I

Question 16

What happens when the interest rate is above the equilibrium level?

Answer 16

At this high interest rate, the amount of desired saving exceeds the amount of desired investment, and this excess supply of financial capital pushes down the price of credit—the real interest rate.

Question 17

What happens when the interest rate is below the equilibrium level?

Answer 17

Conversely, if the interest rate is below at , the quantity of desired investment exceeds the quantity of desired saving, and this excess demand for financial capital pushes up the real interest rate.

Question 18

How could an increase in the supply of national saving happen?

Answer 18

This increase in the supply of national saving could happen either because household consumption (C) falls or because government purchases (G) fall (or because T rises, which reduces C).

Question 19

What effect does a decline in either C or G have on the level of national savings?

Answer 19

A decline in either C or G means that national saving rises at any real interest rate, and so the NS curve shifts to the right.

Question 20

Graph of Increases in Investment Demand and the Supply of National Saving

Answer 20

Question 21

What do changes in the supply of natinal saving or the demand for investment do to equilibrium real interest rate and the rate of growth of potential output?

Answer 21

Changes in the supply of national saving or the demand for investment will change the equilibrium real interest rate and the rate of growth of potential output.

Question 22

What does the increase in supply of NS do to real interest rate and investment?

Answer 22

the increase in the supply of national saving pushes down the real interest rate and encourages more investment

Question 23

What does an increase in demand for investment do to the real interest rate and saving?

Answer 23

the increase in the demand for investment pushes up the real interest rate and encourages more saving.

Question 24

What does the increase in supply of national saving lead to?

Answer 24

The increase in the supply of national saving leads to an excess supply of financial capital and thus to a decline in the real interest rate.

As the interest rate falls, firms decide to undertake more investment projects and the economy moves from the initial equilibrium to the new equilibrium .

At the new equilibrium, more of the economy’s resources are devoted to investment than before, and thus the country’s stock of physical capital is rising at a faster rate.

Since growth in the capital stock is an important reason for growth in potential output, we conclude that the higher rate of investment at leads to a higher growth rate of potential output.

Question 25

In general, what dose an increase in supply of national savings do in the long run?

Answer 25

In the long run, an increase in the supply of national saving reduces the real interest rate and encourages more investment. The higher rate of investment leads to a higher growth rate of potential output.

Question 26

What direction does the investment curve shift when there is an increase in demand for investment?

Answer 26

Investment increases so that the I curve shifts to the right

Question 27

What are some potential reasons for an increase in desired investment?

Answer 27

The increase in desired investment might be caused by technological improvements that increase the productivity of investment goods or by a government tax incentive aimed at encouraging investment.

Question 28

What is the immediete result of an increase in investment demand?

Answer 28

The increase in investment demand creates an excess demand for financial capital and therefore leads to a rise in the real interest rate. The rise in the interest rate encourages households to reduce their current consumption and increase their desired saving.

Question 29

What does an increase in the demand for investment do in the long run?

Answer 29

In the long run, an increase in the demand for investment pushes up the real interest rate and encourages more saving by households. The higher rate of saving (and investment) leads to a higher growth rate of potential output.

Question 30

In long-run equilibrium, what determines the equilibrium real interest rate?

Answer 30

Question 31

What does an increase in the supply of national saving lead to?

Answer 31

Question 32

What does an increase in the demand for investment lead to?

Answer 32

Question 33

What does a shift in either the NS or I curve lead to?

Answer 33

Question 34

What does our long run version of the macro model predict about countries with high rates of investment?

Answer 34

Our long-run version of the macro model predicts that countries with high rates of investment are also countries with high rates of real GDP growth.

There is a positive relationship between a country’s investment rate (as a percentage of GDP) and its growth rate of real per capita GDP.

Question 35

What is the Neoclassical growth model based on?

Answer 35

The Neoclassical growth model is based on the idea that these four sources of economic growth can be connected by what is called the aggregate production function. This is an expression for the relationship between the total amounts of labour (L) and physical capital (K) employed, the quality of labour’s human capital (H), the state of technology (T), and the nation’s total level of output (GDP).

Question 36

What is the Aggregate production function?

Answer 36

Aggregate production function

The relationship between the total amount of each factor of production employed and total GDP.

Question 37

How do we express the aggregate production function?

Answer 37

Question 38

Explain the Aggregate production function

Answer 38

Question 39

What are the key assumptions of the Neoclassical growth model?

Answer 39

The key assumptions of the Neoclassical growth model are that the aggregate production function displays diminishing marginal returns when any one of the factors is increased on its own and constant returns to scale when all factors are increased together (and in the same proportion).

Question 40

What is marginal product?

Answer 40

To begin, suppose the labour force grows while the stock of capital remains constant. More and more people go to work using a fixed quantity of capital. The amount that each new worker adds to total output is called labour’s marginal product.

Question 41

What is Diminshing marginal returns?

Answer 41

Diminishing marginal returns

The hypothesis that if increasing quantities of one factor are applied to a given quantity of other factors, the marginal product of the one factor will eventually decrease.

The concept of diminishing marginal returns tells us that the employment of additional workers (or hours of work) will eventually add less to total output than the previous worker did.

Question 42

What is the second assumption that we make cocerning the aggregate production function?

Answer 42

The other main assumption concerning the aggregate production function is that it displays constant returns to scale. Remember that we are assuming for simplicity that labour and capital are the only two inputs. With constant returns to scale, if L and K both change in an equal proportion, total output will change by that same proportion. For example, if L and K both increase by 10 percent, GDP will also increase by 10 percent.

Question 43

What are Constant returns to scale?

Answer 43

Constant returns to scale

A situation in which output increases in proportion to the change in all inputs as the scale of production is increased.

Question 44

What is the effect to GDP that rusults from an increase in the labor for given a fixed stock of capital?

Answer 44

Over long periods of time, the changes in a country’s labour force tend to mirror the changes in its population. As more workers are employed, more output will be produced. For a given stock of capital, however, the presence of diminishing marginal returns tells us that each additional unit of labour employed will cause smaller and smaller additions to GDP.

Question 45

What is happening to material living standards as the labour for grows with a fixed amount of capital?

Answer 45

With the marginal product and average product of labour falling (with each additional increment to labour), we get an interesting result. Although economic growth continues in the sense that total output is growing, material living standards are actually falling because average GDP per person is falling (real GDP is growing more slowly than the population).

Question 46

What does the Neoclassical growth model with diminsing marginal returns say about increases in population with a fixed stock of capital?

Answer 46

In the Neoclassical growth model with diminishing marginal returns, increases in population (with a fixed stock of capital) lead to increases in GDP but an eventual decline in material living standards.

Question 47

When does growth in physical capital occur?

Answer 47

Growth in physical capital occurs whenever there is positive (net) investment in the economy. For example, if Canadian firms produce $300 billion of capital goods this year, and only $40 billion is for the replacement of old, worn-out equipment, then Canada’s capital stock increases by $260 billion.

Question 48

How does Human capital accumulate?

Answer 48

Human capital has several aspects.

One involves improvements in the health and longevity of the population.

A second aspect of human capital concerns specific training and education—from learning to operate a machine or software program to learning how to be a scientist.

Question 49

How does the accumulation of capital, holding constant the labour force, affect GDP?

Answer 49

The accumulation of capital—either physical or human—affects GDP in a manner similar to labour-force growth. The presence of diminishing marginal returns implies that each successive unit of capital, holding constant the labour force, will add less to total output than each previous unit of capital.

Question 50

Why is dimishing marginal returns in reguards to capital in contrast with that of the Labour force?

Answer 50

There is, however, a major contrast with the case of labour-force growth because it is output per person that determines material living standards, not output per unit of capital.

Question 51

In the Neoclassical growth model, what is the effect of capital accumulation?

Answer 51

In the Neoclassical growth model, capital accumulation leads to improvements in material living standards, but because of diminishing marginal returns, these improvements become smaller with each additional increment of capital.

Question 52

What is “Balanced” growth?

Answer 52

Now consider what happens if labour and capital (both human and physical capital) grow at the same rate. This is what economists call “balanced” growth.

Question 53

What does the Neoclassical assumption of constant returns to scale mean for the GDP when there is balenced growth?

Answer 53

In this case, the Neoclassical assumption of constant returns to scale means that GDP grows in proportion to the increases in inputs.

For example, if capital and labour both increase by 2 percent per year, then GDP also increases by 2 percent per year. As a result, per capita output (GDP/L) remains constant.

Thus, balanced growth in labour and capital leads to growth in total GDP but unchanged per capita GDP.

Question 54

What can Balanced growth NOT explain?

Answer 54

Balanced growth can therefore not explain sustained increases in material living standards. Increases in material living standards require increases in per capita output.

Question 55

In conclusion, what does the Neoclassical growth model with constant returns to scale say about per capita output and material living standards?

Answer 55

If capital and labour grow at the same rate, GDP will increase. But in the Neoclassical growth model with constant returns to scale, such balanced growth will not lead to increases in per capita output and therefore will not generate improvements in material living standards.

Question 56

To summarize, the Neoclassical growth model predicts….

Answer 56

Growth in the labour force alone leads to declining per capita income

Capital accumulation alone leads to positive but ever-diminishing growth rates of per capita income.

Increases in labour and capital together cause an increase in real GDP but leave per capita income unchanged.

Question 57

What is the assumption about technological change assumed to be in the Neoclassical growth model?

Answer 57

In the Neoclassical growth model, technological change is assumed to be exogenous—that is, it is not explained within the model. This assumption is an important weakness of the model because it means that the theory is unable to explain what is undoubtedly the most important determinant of long-run improvements in living standards.

Question 58

What is embodied technical change?

Answer 58

The increase in productive capacity created by installing new and better capital goods is called embodied technical change.

Technical change that is intrinsic to the particular capital goods in use.

Question 59

What does embodied technical change lead to?

Answer 59

Many innovations are embodied in either physical or human capital. These innovations cause continual changes in the techniques of production and in the nature of what is produced. Embodied technical change leads to increases in potential output even if the amounts of labour and capital are held constant.

Question 60

What is Solow residual?

Answer 60

His method led to the creation of what is now called the “Solow residual.” The Solow residual is the amount of growth in GDP that cannot be accounted for by observed growth in the labour force and capital stock.

Question 61

What is another name for Solow residual?

Answer 61

Despite these problems, the Solow residual is still used by many economists in universities and government, and it often goes by another name—the rate of growth of total factor productivity (TFP).