Summary of Economic Growth (Weil, 2013) - written and donated to WorldSupporter in 2014

Chapter 1: The facts to be explained

Measurement of economic development: GDP versus PPP

The indicator commonly used to examine the degree of development of a country’s economy is the Gross Domestic Product (GDP). It measures the market value of all services or final goods produced in a country during a year. It can be calculated as either the total income earned in a country or the value of the output produced in a country.

Economic measurement with the GDP (output or national income) also includes potential problems. For instance, GDP also includes foreign investment and does then not represent wealth in that Country, but the foreign investment value. In addition, many aspects of economic wealth cannot be measured by GDP.

The source of a high total GDP value could be extensive population density, because more people are available as labour force. Therefore, when comparing countries with different population sizes it is advisable to compare the GDP per capita (GDP earned per capita). Despite these potential problems, GDP remains a rough estimate for comparing different living standards.

A further potential problem when comparing GDP values of different countries, is the influence of exchange rates, which are only determined by international traded goods. Therefore, converting different incomes in one exchange rate can create a wrong picture of the true purchasing value of a currency.

Therefore, the Purchasing Power Parity (PPP) provides a measurement of national income based on the relative purchasing power of a currency, measured by the price of a standardized basket, which contains a set of traded and non-traded goods and services. The PPP corrects the GDP per capita measures.

Measurement: growth rates of national income

A country’s growth rate of income can be used as a measurement of the speed of development/growth. The growth rate is important because a country that grows fast will move to a higher level of income in the future.
 

When working with income growth rates, two concepts of graph scales need to be considered:

• The ratio scale (also called logarithmic scale) is mainly used for plotting variables like growth rates which grow over time. Spaces on the vertical axis correspond to proportionality differences in the variable.

• The common linear scale uses equal spaces on the vertical axis, corresponding to equal differences in the variable.

The main difference between those concepts is visible when plotting a constant growing rate over time. The linear scale curve is exponential and the ratio scale curve is straight. (See p.31)

The rule of 72 can be used for dealing with growth rates. It is a formula for estimating the amount of time it takes for something to double given its growth rate. See attachment A.1 for the formula.

Income growth rates vary among countries and also vary during recent decades. The difference between increased output due to business cycles or due to economic growth is mainly time related. Growth is characterized as a long-run trend, whereas business cycles can be defined as short term fluctuations, like recessions, i.e. deviations from the long run trend.

The total income inequality in the world is the result of two inequalities:

1. The difference in income between countries (Between country equality)

2. Inequality of per capita income within a single country (Within country inequality).

The findings from inequality measurement:

• Total inequality highly increased during the period 1820-1950, slowed down 1950-1992 and declined after 1980.

• Today 60% of world total inequality is a result of between country inequality.

• In 1820 87% of world inequality caused by within country inequality.

Growth during different periods:

• Growth Before 1820

Only few data is available for the period before 1820. Still, a significantly low GDP per capita growth rate is characteristic for an economy, which was driven by strong fluctuations due to the dependency on harvest conditions or armed conflicts. However, the income difference gap between countries is still very small. The world political order is dominated by the rapidly progressing Western Europe expansion.

• Growth Since 1820

Worldwide income growth accelerates, with highly increasing average GDP growth per capita, but also the gap between country equality increases. Compare: In 1820 the ratio of comparing wealth between rich and poor countries was 3:1 (3 times as rich), in 1998 the ratio increased to 19:1.

• Growth during the last 35 years

During the last 35 years some countries have experienced high growth rates while others dealt with negative growth rates. The chart on page 35 gives an overview of the growth rates from country-groups in the period between 1975 and 2009. So called “growth miracles” like China face an average annual growth rate of between7,5 % to 8 %. Whereas “growth disasters” like Liberia and Zimbabwe have to face a rate between -4.5 % and -3 %.

Chapter 2: A framework for analysis

Some basic tools

In order to chase the key question of why some countries are rich and whereas others are poor, we will use the basic tools for economic analysis.

Goods and services are produced using two inputs, namely labor and capital.

Capital refers to physical stock like machines, vehicles and other pieces of equipment used during the process of production as well as financial capital, like securities. The more capital that a worker has to work with, the more output the worker produces.

Differences in income between countries can be explained by differences in the capital available per worker in each country. These differences in capital can be explained by differences in investment. Investment is the goods and services used for production rather than for consumption. The investment rate is therefore the fraction of income, which is further invested. A higher investment rate might explain more capital available per worker.

Although investment explains a part of differences in income, most is explained by differences in productivity.

Productivity is the effectiveness, with which output is produced from a certain amount of inputs. Productivity differences can be caused by a technology difference.

Technology is defined by the state of available knowledge about how to do (produce) things. Technological progress increases the produced amount of output with the same input (e.g. Productivity). The way in which available technology and inputs are actually used in production output is called efficiency. The formula which combines technology, efficiency and productivity can be found in attachment B.1.

Factors which influence economic growth immediately are referred to as proximate causes of economic growth. The opposite is called ultimate causes of economic growth, which has only an indirect influence)

The underlying factors of why a country is poor or rich are called the fundamentals. They include culture or geography aspects and economic policies.

The production function

The production function describes the method to generate output, by relating the amount of input factors used to produce the output. These input factors are referred to as factors of production. Input factors are either labour or capital.

According to the productivity function, income inequality in two countries can be due to:

• Differences due to factor accumulation.

• Differences due to productivity

• Both differences in factor accumulation and productivity.

A question that often has been asked is what influence an increase in savings would have on economic growth. Well the answer is that an increase in savings would raise the growth rate of output in the years immediately after it took place, but eventually the growth rate would return to its original level. However the growth rate has not changed in the long run, the level of output would be higher than it would have been when savings had not been increased.

Analysis of Data

Economic theories are often stated in the form of economics models, which are simplified representations of reality that can be used to analyse how economics variables are determined and how a change in one variable will affect others.

In order to find empirical proof for different economic models regarding economic growth, we will have to consider statistical evidence and therefore incorporate the basic statistical terms;

A scatter plot is used to sketch the relationship between two variables, one on the x-axis and one on the y-axis. Each observation is represented by a single point.

Outliers: observations which show a clear deviation from the normal pattern.

Correlation describes the relationship between two variables as one is changing. Is one increasing as the other one also increases (calories consumption/day increases together with GDP increasing) we define that relationship as a strong positive correlation. The degree of correlation is measured with a correlation coefficient, which can take a value between -1 and 1. A value of “0” states that there is no relationship between two variables; e.g. the amount of girls born is not dependent on the amount of sunshine days. There are three possible explanations for the correlation:

• X causes Y: variable X affects variable Y.

• Y causes X: variable Y affects variable X.

• There is no direct causal relationship between X and Y: But there is a third variable, Z, that causes both X and Y. This third variable Z is known as an omitted variable; the two factors do not influence themselves, but are both subject to a change in a third variable.

Reverse causation describes the phenomenon that not X influences Y, but Y effects X. For example, the correlation between cars owned per family and the income, could be interpreted that having more cars will lead to higher income. However, the opposite is true; the two variables have a reverse causation.

Cross-sectional-data: Observations of different units at a single point in time. A way to use these date is to examine how economic variables change over time for a certain period or decade.

Chapter 3: Physical capital

The nature of capital

The term ‘capital’ refers to physical stock of production means like machines, buildings, also infrastructure, used together with labor to produce output. Therefore, the more capital per worker available, the more output can be produced, which points out a striking relationship between capital accumulation and GDP. Differences of capital availability account therefore also for the worldwide income gap between economies. The theory, which tries to examine that relationship, is called Capital-based theory.

Five main key characteristics of capital:

1. The creation/production of capital is defined as investment.

2. Nature of enhanced productivity: more capital available will increase the output that a worker can produce.

3. Rivalry of Capital since capital items can only be used by limited amount of people at the same time.

4. Return of Capital: Because of its productivity enhancing (Point 2) characteristics and Rivalry nature (Point 3) capital will create a return, which is often the incentive to carry out investments in capital.

5. Depreciation; Capital stock will decline in its value over time, either through physical depreciation, reduced demand or obsolescence.

Relationship between capital and productivity

As noted in Point 2 above, capital has the characteristics to increase productivity and therefore output. To assess the degree of that correlation, we will use the production function which relates inputs used and output produced. The two production factors utilized are Labour (L) and Capital (K).

The return of both inputs (Capital and Labour) together has constant returns to scale; if we multiply the quantities of each input by some factor, the quantity output will increase by that same factor, and where each individual separate factor has a diminishing marginal return.

The diminishing marginal product holds on the other hand that adding one more unit of e.g. labour and holding capital constant will increase the output produced less than the unit before (and so on) and less than the input “1”. That law is described by the Cobb-Douglas production function, see attachment C.1 for the formula.

Where A is a measurement for productivity, and ∝ takes values between 0 and 1, which describes the composition of how much capital is used in relation to labour (and vice versa). Therefore, a country with a higher productivity A will have a higher output for a fixed amount of Capital and Labour.

Another implication of the marginal (diminishing) product of labour/capital is that a firm will set the wages (for labour) and rental rate (occurring cost when renting a capital good) in the competitive market equal to its MPL (marginal product of labour) or MPK (marginal product of Capital).

The capital’s share of income is the fraction of national income, Y, that is paid out as rent on capital. See attachment C.2 for the formula of the capital’s share of income.

The Solow model

Robert Solow formulated the neoclassical economic growth model which incorporates Labour, Capital and technological change to explain differences in levels of income per capita and called this model the Solow model. The model focuses on the amount of physical capital that each worker has to work with.

The change in capital is determined by two factors:

• Investment in capital, which increases capital stock, which we will call 'γ'

• Depreciation of capital over time, which reduces the total value of capital which we name 'δ'.

Consequently, the change in capital (per worker in this case) can be written in a formula, see attachment C.3.

Hence, as investment is larger than depreciation, capital grows, is investment smaller than depreciation, the capital will shrink. The steady-state scenario of an economy occurs, when depreciation of capital available per worker is equal to the investment in capital stock per worker. Hence in the steady-state, the capital will not change over time. That is a stable equilibrium; as soon as investment is greater than depreciation, the capital will grow until it reaches the steady-state equilibrium. On the other hand, if depreciation is higher, capital stock will decrease and move back to the equilibrium. The shifting towards the equilibrium is called convergence towards the steady state.

A change in δ or γ, depreciation or investment, will shift either the depreciation, which is assumed to be a straight curve, or the investment with a diminishing growth curve and will thus move the steady state equilibrium.

If we plug the steady-state level of capital per worker into the production function we get an equation of the steady-state level of output per worker, see attachment C.4.

Solow compares the differences in the level of income per worker between two countries by comparing their steady-state levels of output, which is done by dividing one output level in the steady-state equilibrium by the other. Assuming the same level of productivity, the same depreciation rate but differences in the rate of investment, if that is given, we are able to calculate a numerical result, which represents the multiple level of income of country A compared to country B. Therefore, we can interpret the Solow model as a theory of income differences, because it allows us to compare different income level.

• If two countries have the same rate of investment but different levels of income, the country with lower income will have higher growth.

• If two countries have the same level of income but different rates of investment, then the country with a higher rate of investment will have higher growth.

• A country that raises its level of investment will experience an increase in its rate of income growth.

Nevertheless, can we use it to explain growth differences between two economies? In the steady-state level theory, the possibility is not incorporated that countries grow over a long period, because with the steady-state theory each country is supposed to reach its stable steady state equilibrium. Hence, the theory can only be applied if we assume that the countries are located in a convergence towards the steady state.

Investment and Saving

The investment rate plays an important role in Solow’s theory of income differences, because it determines the growth of capital stock. Different rates of investment lead to different steady state levels.

In order to examine what determines the investment rate we will first focus on the saving rate; the rate to which people save. It is determined by the opportunity costs of saving. But the reason why savings rates differ cannot purely be explained by how much people can afford to save, e.g. live above the existence minimum. Factors which influence the saving rate and every economic model are either:

• Endogenous variables: Determined within the model.

• Exogenous variables: Are taken as given when we analyse a model, they are determined outside the mode.

To reduce the complexity of the theory, we assume that saving is endogenous, thus notRead more