Introduction to Economics –ECO401 VU

Lesson 38

THE FOUR BIG MACROECONOMIC ISSUES AND THEIR INTER-RELATIONSHIPS

(CONTINUED)

THE CONCEPT OF ECONOMIC GROWTH AND GROWTH RATE

Economic growth is increase in an economy’s level of production, output or income. We can
talk about production or output in two broad definitional contexts. One, we can compare real
GDP with some other measure of welfare (for e.g., one which adjusts for externalities, social
indicators, the black market, purchasing power parity, income inequality etc.). Two, we can talk
about potential vs. actual output. Potential output is the aggregate capacity output of a nation;
the maximum quantity of goods and services that can be produced with available resources
and a given state of technology. 1 In our discussion here, we will abstract from such
complexities and take output to simply mean real GDP.
The growth rate of a country’s real GDP can be negative, positive or zero. A growth rate of
between 2-3% is considered normal for mature developed countries; for LICs, 5-7% is
considered healthy and 7%+ excellent.

ACTUAL & POTENTIAL GDP

The GDP gap or the output gap is the difference between actual GDP and potential GDP or
potential output. The calculation for the output gap is Y-Y* where Y is actual output and Y* is
potential output or the natural level of output. If this calculation yields a positive number it is
called an expansionary gap and indicates an economy in expansion; if the calculation yields a
negative number it is called a recessionary gap and indicates an economy in recession.
The percentage GDP gap is the actual GDP minus the potential GDP divided by the potential
GDP. (Actual GDP − potential GDP) / Potential GDP.

M Actual & potential GDP

E
B
A

PPF1 PPF2
O
A

TRADITIONAL THINKING ABOUT GROWTH

Traditional thinking on growth was that it can be driven either by an increase in factor
resources (land, natural resources, labour, capital), i.e. an increase in potential GDP, or by
more efficient use of the factors, i.e. a move from inside the PPF to the PPF. The policy
implication attached to this line of thinking was simple. Countries must either accumulate
factors of production (esp. capital), or develop more cost-efficient technologies and methods of
production to utilize those resources better. In any event, factors of production were at the
heart of growth theory.

1
Thus, when the production possibilities frontier of a country shifts out, that represents an increase in potential
GDP. Actual GDP can be less than or equal to potential GDP, and is usually less. The difference between potential
and actual GDP is sometimes referred to as the output gap.

© Copyright Virtual University of Pakistan 1

Introduction to Economics –ECO401 VU

Trade cycle
1 = The upturn
2 = The boom
3 = The peaking out
4 = The slowdown, recession or slump
put
ut
outp
ntial
out
nal Pote
atio 3
N 4

2 Actual output

3
4
2 1

1
O
Time
REAL VS NOMINAL GDP
Nominal GDP measures the value of output during a given year using the prices prevailing
during that year. Over time, the general level of prices rises due to inflation, leading to an
increase in nominal GDP even if the volume of goods and services produced is unchanged.
Real GDP measures the value of output in two or more different years by valuing the goods
and services adjusted for inflation. For example, if both the "nominal GDP" and price level
doubled between 1995 and 2005, the "real GDP” would remain the same. For year over year
GDP growth, "real GDP" is usually used as it gives a more accurate view of the economy.
Relation between Real GDP and Nominal GDP
Nominal GDP is calculated using current prices whereas real GDP uses constant prices. The
difference between the nominal GDP and real GDP is due to the inflation rate in market. The
relationship between inflation, real GDP and nominal GDP is explained by Fisher Equation.
Real GDP = Nominal GDP – Inflation

AGGREGATE GDP VS PER CAPITA REAL GDP

Economy’s total income or the sum total of all incomes in an economy in a given period,
usually a year is known as the aggregate GDP or aggregate income level.
When studying growth, it is always instructive to analyze changes in per capita real GDP along
with changes in real GDP. Per capita real GDP growth adjusts GDP growth downwards by the
population growth rate and gives a more accurate indication of improvements in living
standards in a country. For mature HICs, Real GDP growth rate = per capita real GDP growth
rate, since the population size in these countries is quite stable.
It is also important to note that even a small per capital real GDP growth rate (say around 2%
p.a.), if sustained for a very long very of time (say 100 years) can deliver huge improvements
in living standards. The U.S. and Japan in the 19 th and 20th centuries and East Asian tiger
economies in the last four decades are a neat example of this.
Why Growth is an Important Macroeconomic Issue:
It is obvious why growth is an important macroeconomic issue. Every government aspires to
deliver a higher growth rate for the country. High growth rates means higher national income
which means better living standards on average, which in democracies, means happier
electorates and therefore increased chances of re-election for another term in office. However,
while all countries might wish to achieve high growth rates, in practice, only a handful have
been able to convert the wish into reality.

HOW PER CAPITA GROWTH RATES RELATED TO THE AGGREGATE GROWTH RATE
IN AN ECONOMY? DEFINING GDP GROWTH RATE
y=Y/L
Where,
• Y = Total GDP

© Copyright Virtual University of Pakistan 2

Introduction to Economics –ECO401 VU

• L = Population
• y = Per capita GDP
Taking log of both sides
• ln y = ln Y – ln L
Taking derivative w.r.t. time
• 1 (dy/dt) = (dY/dt) – (dL/dt)
y Y L
gy = gY – gL
Growth rate of per capita income = Growth rate of total output - Growth rate of population

Real Gross Domestic Production figures

Ratio of 1999 /
Countries Annual growth
1870
Japan 100 3.7
US 66 3.4
Australia 43 3.1
Sweden 33 2.8
France 15 2.2
UK 10 1.9

RGDP per capita figures

Ratio of 1999 /
Countries Annual growth
1870
Japan 27 2.7
US 10 1.8
Australia 4 1.2
Sweden 14 2.2
France 10 1.9
UK 5 1.3

Pakistan’s growth rate statistics since independence

Era Aggregate Real GDP

60s 6.7
70s 4.8
80s 6.4
90s 4.7

Per Capita RGDP Population

4 2.7
Reference: Zaidi.A,
Issues in Pakistan’s 1.7 3.1
Economy 3.3 3.1
LINK BETWEEN 2 2.7
GROWTH AND THE
VARIOUS FACTORS OF PRODUCTION
Capital:

© Copyright Virtual University of Pakistan 3

Introduction to Economics –ECO401 VU

Any increase in capital should cause an increase in growth rate of output. Capital deepening
is a term used in economics to describe an economy where capital per worker is increasing. It
is an increase in the capital intensity. Capital deepening is often measured by the capital stock
per labour hour. Overall, the economy will expand, and productivity per worker will increase.
However, economic expansion will not continue indefinitely through capital deepening alone.
This is partly due to diminishing returns and wear & tear. Capital widening is a term used to
describe the situation where capital stock is increasing at the same rate as the labour force,
thus capital per worker remains constant. The economy will expand in terms of aggregate
output, but productivity per worker will remain constant.
Labor:
Human capital also matters for economic growth. Quantity as well as the quality of labor
should also be considered. This is also an engine of growth.
Land:
Pakistan is an agrarian country in which land matters much. Japan and Korea has been grown
rapidly because they have used their scarce land very efficiently.
Raw materials:
If stock of raw materials increases economy will produce more output which will increases
growth rate of output.
Technical knowledge:
If there are technical advancements then production will increase, growth rate of output will
also increase. The factors of technological advancements are learning by doing, invention,
innovation etc.

© Copyright Virtual University of Pakistan 4