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Now fast-forward more than a century. By 1979, the United States had become the
world™s preeminent economic power, Japan had emerged as the clear number two, and
the United Kingdom had retreated into the second rank of nations. Obviously, the
Japanese economy grew faster than the U.S. economy during this century, while the
British economy grew more slowly, or else this stunning transformation of relative posi-
tions would not have occurred. But the magnitudes of the differences in growth rates
may astound you.
Over the 109-year period, GDP per capita in the United States grew at a 2.3 percent
compound annual rate while the United Kingdom™s growth rate was 1.8 percent”a dif-
ference of merely 0.5 percent per annum, but compounded for more than a century. And
what of Japan? What growth rate propelled it from obscurity into the front rank of na-
tions? The answer is just 3.0 percent, a mere 0.7 percent per year faster than the United
States. These numbers show vividly what a huge difference a 0.5 or 0.7 percentage point
change in the growth rate makes, if sustained for a long time. Labor productivity is the
amount of output a worker
Economists define the productivity of a country™s labor force (or “labor productivity“)
turns out in an hour (or a
as the amount of output a typical worker turns out in an hour of work. For example, if
week, or a year) of labor. If
output is measured by GDP, productivity would be measured by GDP divided by the to-
output is measured by GDP,
tal number of hours of work. It is the growth rate of productivity that determines whether it is GDP per hour of work.
living standards will rise rapidly or slowly.
out in our list of Ideas for Beyond the Final Exam, only rising productivity can raise stan-
dards of living in the long run. Over long periods of time, small differences in rates of
productivity growth compound like interest in a bank account and can make an enor- BEYOND THE
mous difference to a society™s prosperity. Nothing contributes more to material well- FINAL EXAM

being, to the reduction of poverty, to increases in leisure time, and to a country™s ability
to finance education, public health, environmental improvement, and the arts than its
productivity growth rate.

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Part 2
108 The Macroeconomy: Aggregate Supply and Demand

How fast should the U.S. economy, or any economy, grow? At first, the question
may seem silly. Isn™t it obvious that we should grow as fast as possible? After all,
that will make us all richer. In a broad sense, economists agree; faster growth is
generally preferred to slower growth. But as we shall see in a few pages, further
thought suggests that the apparently naive question is not quite as silly as it
sounds. Growth comes at a cost. So more may not always be better.

Questions like how fast our economy can or should grow require quantitative answers.
Economists have invented the concept of potential GDP to measure the economy™s nor-
Potential GDP is the real
GDP that the economy mal capacity to produce goods and services. Specifically, potential GDP is the real gross
would produce if its labor domestic product (GDP) an economy could produce if its labor force was fully employed.
and other resources were
Note the use of the word normal in describing capacity. Just as it is possible to push a fac-
fully employed.
tory beyond its normal operating rate (by, for example, adding a night shift), it is possible
to push an economy beyond its normal full-employment level by working it very hard. For
The labor force is the
number of people holding example, we observed in the last chapter that the unemployment rate dropped as low as
or seeking jobs. 1.2 percent under abnormal conditions during World War II. So when we talk about em-
ploying the labor force fully, we do not mean a measured unemployment rate of zero.
Conceptually, we estimate potential GDP in two steps. First, we count up the available
supplies of labor, capital, and other productive resources. Then we estimate how much
output these inputs could produce if they were all fully utilized. This second step”the
transformation of inputs into outputs”involves an assessment of the economy™s technol-
ogy. The more technologically advanced an economy, the more output it will be able to
The economy™s produce from any given bundle of inputs”as we emphasized in Chapter 3™s discussion of
production function
the production possibilities frontier.
shows the volume of output
To help us understand how technology affects the relationship between inputs and out-
that can be produced from
puts, it is useful to introduce a tool called the production function”which is simply a
given inputs (such as labor
mathematical or graphical depiction of the relationship between inputs and outputs. We
and capital), given the
will use a graph in our discussion.
available technology.
For a given level of technology, Figure 1 shows how output (measured by real GDP on
the vertical axis) depends on labor input (measured by hours of work on the horizontal
F I GU R E 1
The Economy™s
Production Function
SOURCE: Bureau of Labor Statistics. Data pertain to the nonfarm business sector.

M Y1
Real GDP

Real GDP

K K0
Y0 Y0

L0 L0
0 0
Labor input Labor input
(hours) (hours)

(a) Effect of better technology (b) Effect of more capital

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Chapter 6 109
The Goals of Macroeconomic Policy

axis). To read these graphs, and to relate them to the concept of potential GDP, begin with
the black curve OK in Figure 1(a), which shows how GDP depends on labor input, holding
both capital and technology constant. Naturally, output rises as labor inputs increase as we
move outward along the curve OK, just as you would expect. If the country™s labor force
can supply L0 hours of work when it is fully employed, then potential GDP is Y0 (see point A).
If the technology improves, the production function will shift upward”say, to the brick-
colored curve labeled OM”meaning that the same amount of labor input will now pro-
duce more output. The graph shows that potential GDP increases to Y1.
Now what about capital? Figure 1(b) shows two production functions. The black curve
OK0 applies when the economy has some lower capital stock, K0. The higher, brick-colored
curve OK1 applies when the capital stock is some higher number, K1. Thus, the production
function tells us that potential GDP will be Y0 if the capital stock is K0 (see point A) but Y1
if the capital stock is K1 instead (see point B). Once again, this relationship is just what you
would expect: The economy can produce more output with the same amount of labor if
workers have more capital to work with.
You can hardly avoid noticing the similarities between the two panels of Figure 1: Bet-
ter technology, as in Figure 1(a), or more capital, as in Figure 1(b), affect the production
function in more or less the same way. In general:
Either more capital or better technology will shift the production function upward and
therefore raise potential GDP.

With this new tool, it is but a short jump to potential growth rates. If the size of potential GDP
depends on the size of the economy™s labor force, the amount of capital and other resources it
has, and its technology, it follows that the growth rate of potential GDP must depend on
• The growth rate of the labor force
• The growth rate of the nation™s capital stock
• The rate of technical progress
To sharpen the point, observe that real GDP is, by definition, the product of the total
hours of work in the economy times the amount of output produced per hour”what we
have just called labor productivity:
GDP 5 Hours of work 3 Output per hour 5 Hours of work 3 Labor productivity.
For example, in the United States today, in round numbers, GDP is about $14 trillion
and total hours of work per year are about 250 billion. Thus labor productivity is roughly
$14 trillion/250 billion hours 5 $56 per hour.
How fast can the economy increase its productive capacity? By transforming the pre-
ceding equation into growth rates, we have our answer: The growth rate of potential GDP
is the sum of the growth rates of labor input (hours of work) and labor productivity:1
Growth rate of potential GDP 5 Growth rate of labor input 1 Growth rate of labor
In the United States in recent years, labor input has been increasing at a rate of about
1 percent per year. But labor productivity growth, which was very slow until the mid-
1990s, has leaped upward since then”averaging about 2.6 percent per annum from 1995
to 2007. Together, these two figures imply an estimated growth rate of potential GDP in
the 3.6 percent range over the past dozen years.

You may be wondering about what happened to capital. The answer, as we have just seen in our discussion of

the production function, is that one of the main determinants of potential GDP, and thus of labor productivity, is
the amount of capital that each worker has to work with. Accordingly, the role of capital is incorporated into the
productivity number, that is, the growth rate of labor productivity depends on the growth rate of capital.

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Part 2
110 The Macroeconomy: Aggregate Supply and Demand

Do the growth rates of potential GDP and actual GDP match up? The answer is an
important one to which we will return often in this book:
Recent Growth Rates of Real
GDP in the United States
Over long periods of time, the growth rates of actual and potential GDP are nor-
mally quite similar. But the two often diverge sharply over short periods owing to
Growth Rate
Years per Year cyclical fluctuations.
1995“1997 4.1% Table 1 illustrates this point with some recent U.S. data. Since 1994, GDP growth
1997“1999 4.3
rates over two-year periods have ranged from as low as 2.1 percent per annum to as
1999“2001 2.2
high as 4.3 percent. Over the entire 12-year period, GDP growth averaged 3.1 per-
2001“2003 2.1
cent, which is probably just a bit above current estimates of the growth rate of
2003“2005 3.4
2005“2007 2.5 potential GDP.
1995“2007 3.1 The next chapter is devoted to studying the determinants of economic growth and
some policies that might speed it up. But we already know from the production func-
SOURCE: U.S. Department of Commerce.
tion that there are two basic ways to boost a nation™s growth rate”other than faster
population growth and simply working harder. One is accumulating more capital. Other
things being equal, a nation that builds more capital for its future will grow faster. The
other way is by improving technology. When technological breakthroughs are coming at a
fast and furious pace, an economy will grow more rapidly. We will discuss both of these
factors in detail in the next chapter. First, however, we need to address the more basic
question posed earlier in this chapter.

It might seem that the answer to this question is obviously yes. After all,
faster growth of either labor productivity or GDP per person is the route to
higher living standards. But exceptions have been noted.
For openers, some social critics have questioned the desirability of faster
economic growth as an end in itself, at least in the rich countries. Faster
growth brings more wealth, and to most people the desirability of wealth is
beyond question. “I™ve been rich and I™ve been poor. Believe me, honey, rich is better,”
singer Sophie Tucker once told an interviewer. And most people seem to share her sen-
timent. To those who hold this belief, a healthy economy is one that produces vast
quantities of jeans, pizzas, cars, and computers.
Yet the desirability of further economic growth for a society that is already quite
wealthy has been questioned on several grounds. Environmentalists worry that the
sheer increase in the volume of goods imposes enormous costs on society in the form
of crowding, pollution, global climate change, and proliferation of wastes that need dis-
posal. It has, they argue, dotted our roadsides with junkyards, filled our air with pollu-
tion, and poisoned our food with dangerous chemicals.
Some psychologists and social critics argue that the never-ending drive for more and
better goods has failed to make people happier. Instead, industrial progress has trans-
formed the satisfying and creative tasks of the artisan into the mechanical and dehu-
manizing routine of the assembly-line worker. In the United States, it even seems to be
driving people to work longer and longer hours. The question is whether the vast out-
pouring of material goods is worth all the stress and environmental damage. In fact,
surveys of self-reported happiness show that residents of richer countries are no hap-
pier, on average, than residents of poorer countries.
But despite this, most economists continue to believe that more growth is better than
less. For one thing, slower growth would make it extremely difficult to finance pro-
grams that improve the quality of life”including efforts to protect the environment.
Such programs are costly, and the evidence suggests that people are willing to pay for
them only after their incomes reach a certain level. Second, it would be difficult to
prevent further economic growth even if we were so inclined. Mandatory controls are
abhorrent to most Americans; we cannot order people to stop being inventive and
hardworking. Third, slower economic growth would seriously hamper efforts to

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