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SOURCE: International Labour Organization, Key Indicators of
GDP per Hour GDP per Hour
the 25 years covered in Table 1 in several countries that of Work 1980 of Work 2005
have lower average incomes than the United States. For ex- (as percentage (as percentage Growth

the Labour Market (Geneva: 2007), Table 18A (at
Country of U.S.) of U.S.) Rate
ample, productivity in South Korea, Ireland, France, and
the United Kingdom all grew faster than in the United United States 100 100 1.7
States. Why? While a typical Irish worker in 1980 had far France 86 99 2.3
less physical and human capital than a typical American United Kingdom 71 85 2.4
Spain 62 62 1.7
worker, and used substantially less-advanced technology,

Ireland 57 96 3.9
the capital stock, average educational attainment, and level
Argentina 51 37 0.4
of technology all increased faster in Ireland than in the Mexico 44 25 2 0.5
United States. Brazil 33 23 0.2
South Korea 20 48 5.4
The level of productivity in a nation depends on its sup-
plies of human and physical capital and the state of its NOTE: All productivity data are measured in U.S. dollars. So countries whose
currencies rise relative to the U.S. dollar gain on the United States, whereas
technology. But the growth rate of productivity depends countries whose currencies fall relative to the U.S. dollar lose ground.
on the rates of increase of these three factors.
The distinction between productivity levels and productivity growth rates may strike
you as a piece of pedantic arithmetic, but it has many important practical applications.
Here is a particularly striking one. If the productivity growth rate is higher in poorer
countries than in richer ones, then poor countries will close the gap on rich ones. The
so-called convergence hypothesis suggests that this is what normally happens. The convergence
hypothesis holds that
The Convergence Hypothesis: The productivity growth rates of poorer countries tend to nations with low levels of
be higher than those of richer countries. productivity tend to have
high productivity growth
The idea behind the convergence hypothesis, as illustrated in Figure 2, is that productiv-
rates, so that international
ity growth will typically be faster where the initial level of productivity is lower. In this productivity differences
hypothetical example, the poorer country starts out with a per-capita GDP of $2,000, just shrink over time.
one-fifth that of the richer country. But the poor country™s real GDP per capita grows
faster, so it gradually narrows the relative income gap.
Why might we expect such convergence to be the norm? In some poor countries, the
supply of capital may be growing very rapidly. In others, educational attainment may be
rising quickly, albeit from a low base. But the main reason to expect convergence in the F I GU R E 2
long run is that low-productivity countries should be able to learn from high-productivity coun- The Convergence
tries as scientific and managerial know-how spreads around the world. Hypothesis
A country that is operating at the technological
frontier can improve its technology only by inno-
vating. It must constantly figure out ways to do
Richer country
things better. But a less advanced country can
boost its productivity simply by imitating, by
adopting technologies that are already in common
use in the advanced countries. Not surprisingly, it
is much easier to “look it up” than to “think it up.” Poorer country
Real GDP per Capita

Modern communications assist the convergence
process by speeding the flow of information
around the globe. The Internet was invented
mainly in the United States and the United King-
dom, but it quickly spread to almost every corner
of the world. Likewise, advances in human ge-
nomics and stem-cell research are now originating
in some of the most advanced countries, but they
are communicated rapidly to scientists all over the
world. A poor country that is skilled at importing Time
scientific and engineering advances from the rich

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138 The Macroeconomy: Aggregate Supply and Demand

countries can achieve very rapid productivity growth. Indeed,
when Japan was a poor nation, successful imitation was one of its
Levels and Growth Rates of GDP per Capita
secrets to getting rich. India and China are trying that now”with
in Selected Poor Countries
considerable success.

SOURCE: World Bank, World Development
GDP GDP Per Capita
Unfortunately, many poor countries seem unable to participate
per Capita, Growth Rate,
in the convergence process. For a variety of reasons (some of which
Country 2005* 1990 “2005
will be mentioned later in this chapter), a number of developing
Belarus $1,868 2.0%
countries seem incapable of adopting and adapting advanced tech-
Russia 2,445 20.4
nologies. In fact, Table 1 shows that per-capita incomes in some of
Ukraine 960 22.4
Indicators, 2007.
these nations actually grew more slowly than in the rich countries
Peru 2,337 2.3
Haiti 434 22.4 over the quarter-century covered by the table. Labor productivity
Burundi 105 22.5 in Argentina and Brazil both grew much slower than that of the
Sierra Leone 218 20.9
United States, for example, while Mexico™s productivity (when
measured in U.S. dollars) actually declined. Sadly, this kind of de-
* In constant 2000 U.S. dollars.

cline is not all that unusual. Real incomes have stagnated or even fallen in some of the
poorest countries of the world, especially in Africa and many of the formerly communist
countries (see Table 2). Convergence certainly cannot be taken for granted.
Technological laggards can, and sometimes do, close the gap with technological leaders
by imitating and adapting existing technologies. Within this “convergence club,” produc-
tivity growth rates are higher where productivity levels are lower. Unfortunately, some
of the world™s poorest nations have been unable to join the club.

Let us now see how the government might spur growth by working on these three pillars,
beginning with capital.
First, we need to clarify some terminology. We have spoken of the supply of capital, by
A nation™s capital is its
available supply of plant, which we mean the volume of plant (factories, office buildings, and so on), equipment
equipment, and software. (drill presses, computers, and so on), and software currently available. Businesses add to
It is the result of past deci-
the existing supply of capital whenever they make investment expenditures”purchases
sions to make investments
of new plant, equipment, and software. In this way, the growth of the capital stock de-
in these items.
pends on how much businesses spend on investment. That process is called capital
Investment is the flow of formation”literally, forming new capital.
resources into the produc- But you don™t get something for nothing. Devoting more of society™s resources to pro-
tion of new capital. It is the
ducing investment goods generally means devoting fewer resources to producing con-
labor, steel, and other
sumer goods. A production possibilities frontier like those introduced in Chapter 3 can be
inputs devoted to the
used to depict the nature of this trade-off”and the choices open to a nation. Given its
construction of factories,
technology and existing resources of labor, capital, and so on, the country can in principle
warehouses, railroads, and
select any point on the production possibilities frontier AICD in Figure 3. If it picks a point
other pieces of capital dur-
ing some period of time. like C, its citizens will enjoy many consumer goods, but it will not be investing much for
the future. So it will grow slowly. If, on the other hand, it selects a point like I, its citizens
Capital formation is
will consume less today, but the nation™s higher level of investment means it will grow more
synonymous with invest-
quickly. Thus, at least within limits, the amount of capital formation and growth can be
ment. It refers to the
process of building up the
capital stock. Now suppose the government wants the capital stock to grow faster, that is, it wants to
move from a point like C toward a point like I in Figure 3. In a capitalist, market economy
such as ours, private businesses make almost all investment decisions”how many facto-
ries to build, how many computers to purchase, and so on. To speed up the process of cap-
ital formation, the government must somehow persuade private businesses to invest
more. But how?

Real Interest Rates The most obvious way to increase investment by private busi-
nesses is to lower real interest rates. When real interest rates fall, investment normally
rises. Why? Because businesses often borrow to finance their investments, and the real

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Chapter 7 139
Economic Growth: Theory and Policy

interest rate indicates how much firms must pay for that privi-
lege. An investment project that looks unattractive at an interest
rate of 10 percent may look highly profitable if the firm has to

Investment Goods Produced
pay only 6 percent.
The amount that businesses invest depends on the real inter- I
est rate they pay to borrow funds. The lower the real rate of
interest, the more investment there will be.
In subsequent chapters, we will learn how government policy, C
especially monetary policy, influences interest rates”which gives
policy makers some leverage over private investment decisions.
That relationship, in fact, is why monetary policy will play such a
crucial role in subsequent chapters. But we might as well come Consumer Goods Produced
clean right away: For reasons to be examined later, the govern-
ment™s ability to control real interest rates is imperfect. Further-
F I GU R E 3
more, the rate of interest is only one of several determinants of investment spending. So
Choosing between
policy makers have only a limited ability to affect the level of investment by manipulating
Investment and
interest rates. Consumption

Tax Provisions The government also can influence investment spending by altering
various provisions of the tax code. For example, President George W. Bush and Congress
reduced the tax rate on capital gains”the profit earned by selling an asset for more than
you paid for it”in 2003. The major argument for lowering capital gains taxes was the
claim, much disputed by the critics, that it would lead to greater investment spending. In
addition, the United States imposes a tax on corporate profits and can reduce that tax
to spur investment as well. There are other, more complicated tax provisions relating to
investment, too.3 To summarize:
The tax law gives the government several ways to influence business spending on invest-
ment goods. But influence is far from total control.

Technical Change Technology, which we have listed as a separate pillar of growth,
also drives investment. New business opportunities suddenly appear when a new prod-
uct such as the mobile telephone is invented or when a technological breakthrough makes
an existing product much cheaper or better, as is happening with flat-panel TVs right now.
In a capitalist system, entrepreneurs pounce on such opportunities”building new facto-
ries, stores, and offices, and buying new equipment. Thus, if the government can figure
out how to spur technological progress (a subject discussed later in this chapter), those
same policies will probably boost investment.

The Growth of Demand Rapid growth itself can induce businesses to invest more.
When demand presses against capacity, executives are likely to believe that new factories
and machinery can be employed profitably”which creates strong incentives to build new
capital. Thus it was no coincidence that investment soared in the United States during the
boom years of the 1990s, collapsed when the economy slowed precipitously in 2000“2001,
and then revived again starting in 2003. By contrast, if machinery and factories stand idle,
businesses may find new investments unattractive. In summary:
High levels of sales and expectations of rapid economic growth create an atmosphere
conducive to investment.
This situation creates a kind of virtuous cycle in which high rates of investment boost
economic growth, and rapid growth boosts investment. Of course, the same process can
also operate in reverse”as a vicious cycle: When the economy stagnates, firms do not
want to invest much, which damages prospects for further growth.

But any kind of a tax cut will reduce government revenue. Unless that revenue is made up by a spending cut or

by some other tax, the government™s budget deficit will rise”which will also affect investment. We will study
that channel in Chapter 15.

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Part 2
140 The Macroeconomy: Aggregate Supply and Demand

Political Stability and Property Rights There is one other absolutely critical deter-
minant of investment spending that Americans simply take for granted.


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