1

Chapter 5: Long-Run Economic Growth

After reading this chapter, you should be able to:
5.1 Discuss the connection between labor productivity and the standard of living (pages x x)
5.2 Use the Solow Growth Model to Explain the Effect of Capital Accumulation on Labor
Productivity (pages x x)
5.3 Explain how total factor productivity affects labor productivity (pages x x)
5.4 Explain the balanced growth path and convergence and the long-run equilibrium (pages x
x)

Chapter Opener: Labor Productivity and the Standard of Living in China and the United
States
In 2008 China had a population of 1.3 billion people and its economy employed 772.8 million
workers while the United States has a population of just 301.3 million people and the U.S.
economy employs 156.3 million workers. Given these differences in population and growth
rates of real GDP, you might conclude that China had a much larger economy and a higher
standard of living than the United States. However, the opposite is true; the standard of living
was 5.5 times higher in the United States than China. How was this possible? The average
worker in the United States produced 6.4 times as many goods and services than the average
worker in China. Productivity is the key to understanding the standard of living. Understanding
2

why these productivity differences exist is the key to understanding why the standard of living
varies across countries.
Even though the standard of living is higher in the United States, the Chinese economy has
been growing much more rapidly than the U.S. economy. The growth rate of real GDP in China
has averaged 8.5 percent per year from 1980 to 2008 while the growth rate of real GDP in the
United States has averaged just 2.9 percent over the same time period. Furthermore, the Chinese
Premier Wen Jiabao on March 5, 2010 reaffirmed his countrys commitment to achieve 8 percent
real GDP growth for 2010 and China is expected to aim for similarly high growth rates in the
future. The rapid Chinese growth rates mean that the Chinese economy is growing larger
relative to the U.S. economy. However, as we just saw the standard of living is still higher in the
United States than in China.
SOURCE: Penn World Tables. Poon, Terrence; Back, Aaron; and Wu, J.R. China Economy
Still Needs Support, Wall Street Journal, March 5, 2010.

An Inside Look [or An Inside Look at Policy] on page xx explores.
Big Question for This Chapter:
In Chapter 1, we introduced 10 big questions in macroeconomics. Here are the big questions we
return to in this chapter:
Big Question 1: Why has the standard of living increased over the last two hundred years?
Big Question 2: Why have some countries failed to achieve sustained economic growth?
3

We start by explaining the connection between labor productivity and the standard of living.
As you read this chapter, see if you can answer these questions. You can check your answers
against those we provide at the end of the chapter.
Continued on page xx
[Transition statement]
In Chapter 4, we learned that capital per worker hour and Total Factor Productivity (TFP) are the
key determinants of potential real GDP per worker hour. In this chapter, we explain the
determinants of capital per worker hour and total factor productivity. Real GDP per worker hour
is important because both potential real GDP and potential real GDP per worker hour are closely
tied to labor productivity.
[End transition statement]
5.1 Discuss the Connection between Labor Productivity and the Standard of Living
The circular flow diagram in Figure 2-1 showed us that real GDP equals the income
generated in an economy. So, real GDP per person is a measure of both the income available to
the average person in the country and how many goods and services the average person can
purchase. Economists assume that people are rational and purchase goods and services that
make themselves better off. For example, if you are hungry then you buy food. If you are cold,
then you buy shelter. As your income increases, you use the extra income to purchase goods and
services that make you better off. For this reason, economists often use real GDP per person as a
measure of the standard of living.
4

Figure 5-1 shows real GDP per person from 1820 to 2008 for several countries and
Figure 5-1 Real GDP per Person, 1820-2008

SOURCE: Angus Maddison. Data available at: http://www.ggdc.net/maddison/.
Caption: The levels of real GDP per person varied significantly in 1820 with Africa at $420 per
person and the United Kingdom at $1,706. However, the relative rankings of countries by real
GDP per person have changed because the growth rates of real GDP per person have varied. For
example, the growth rate of real GDP per person averaged just 0.8 percent per year in Africa.
This is an extremely low growth rate and in 2008 real GDP per person was just $1,780 in Africa.
Some African countries such as Malawi, Niger, and Zambia still have real GDP per persons of
5

$744, $514, and $845. For all intents and purposes, growth has not come to many countries in
Africa. In contrast, Japans growth rate averaged 1.9 percent per year so real GDP per person in
Japan rose from $669 in 1820 to $22,816 in 2008. Real GDP per person in China was stagnant
until the 1970s and then accelerated rapidly from essentially zero percent to over eight percent
per year. As a result, of these differences in growth rates, the relative rankings of regions by real
GDP per person have also changed. In 1820, the United Kingdom had the highest real GDP per
person, but now the United States has a higher and Japan has the same real GDP per person.
End Caption
regions around the world. The levels of real GDP per person varied significantly in 1820 with
Africa at $420 per person and the United Kingdom at $1,706. However, the relative rankings of
countries by real GDP per person have changed because the growth rates of real GDP per person
have varied. For example, the growth rate of real GDP per person averaged just 0.8 percent per
year in Africa. This is an extremely low growth rate and in 2008 real GDP per person was just
$1,780 in Africa. Some African countries such as Malawi, Niger, and Zambia still have real
GDP per persons of $744, $514, and $845. For all intents and purposes, growth has not come to
many countries in Africa. In contrast, Japans growth rate averaged 1.9 percent per year so real
GDP per person in Japan rose from $669 in 1820 to $22,816 in 2008. Real GDP per person in
China was stagnant until the 1970s and then accelerated rapidly from essentially zero percent to
over eight percent per year. As a result, of these differences in growth rates, the relative rankings
of regions by real GDP per person have also changed. In 1820, the United Kingdom had the
highest real GDP per person, but now the United States has a higher and Japan has the same real
GDP per person.
6

The standard of living is related to labor productivity through the following equation:
(5.1) (

) (

) (

),
so the standard of living equals labor productivity, (

), times labor input, (

).
Both labor productivity and labor inputs influence the standard of living, but the most important
determinant of the standard of living is labor productivity. Even if every man, woman, and child
in a country worked 24 hours a day 365 days a year, each person can work no more than 8,760
hours per year because people need sleep and eat, children go to school, and older people retire.
Although there is a clear limit to how much the labor input can increase real GDP per person,
there is no limit to labor productivity as long as productivity increases, real GDP per person
can also increase. Once we have explained labor productivity, we have explained most of real
GDP per person and the standard of living.
Labor productivity rose from $13.47 per worker hour in 1949 to $47.26 per worker hour
in 2008, but labor inputs actually decreased somewhat from 837.3 hours per person in 1949 to
830.0 hours per person in 2008 for reasons that we will discuss in Chapter 7. The decrease in
labor inputs should reduce the potential real GDP per person. So, the entire increase in potential
real GDP per person is due to increased productivity. We can use equation (5.1) to calculate
what potential real GDP per person would have been if labor productivity had remained at 1949
levels and if labor inputs had remained at 1949 levels. Figure 5-2 shows these two series along
with the actual level of potential real GDP
Figure 5-2 Influence of Labor Productivity and Labor Inputs on Real GDP per Person,
1949 - 2008
7



SOURCE: Bureau of Economic Analysis, Bureau of the Census, and Congressional Budget
Office.
Caption: The blue line represents potential real GDP per person, the green line represents real
GDP per person if hours per person remained at 1949 levels, and the red line represents potential
real GDP per person if labor productivity remained at 1949 levels. If labor productivity remains
constant at the 1949 level, then potential real GDP per person barely changes and is just $11,177
by 2007. However, if labor inputs remain constant at the 1949 level, then potential real GDP per
person rises all the way to $39,574 by 2007. Clearly, labor productivity is the main determinant
of the increase in potential real GDP per person.
8


End Caption
per person. The blue line represents potential real GDP per person, the green line represents real
GDP per person if hours per person remained at 1949 levels, and the red line represents potential
real GDP per person if labor productivity remained at 1949 levels. If labor productivity remains
constant at the 1949 level, then potential real GDP per person barely changes and is just $11,177
by 2007. However, if labor inputs remain constant at the 1949 level, then potential real GDP per
person rises all the way to $39,574 by 2007. Clearly, labor productivity is the main determinant
of the increase in potential real GDP per person.
Problems with Real GDP per person as a Measure of the Standard of Living
Real GDP per person is not a perfect measure of the standard of living, but it is likely the
best measure that we have. As long as people use their income to purchase goods and services
that make them better off, then the standard of living should increase with real GDP per person.
Nevertheless, there are several objections to using real GDP per person as a measure of the
standard of living that we consider in more detail:
Distribution of income
Value of leisure time
Happiness
Life Expectancy
Distribution of Income
9

Real GDP per person is just an average it tells you what the average person in the
economy can consume. However, an average can be misleading because it does not tell you
about the distribution of income. Table 5-2 illustrates this problem using an example of two
people in two countries.
Table 5-2 Income Distribution and Real GDP per Person
Country 1 Country 2
Person 1 $50,000 $99,000
Person 2 $50,000 $1,000
GDP per Person $50,000 $50,000

In country 1, each person earns exactly $50,000 so GDP per person is $50,000 and tells you how
many goods and services the typical person can consume. In this case, real GDP per person is a
very good measure of the standard of living for the typical person. However, this approximation
is not very good for country 2. In country 2, person 1 has an income of $99,000, and person 2
has an income of just $1,000. GDP per person is still $50,000, but person 1 can consume much
more than that amount and person 2 can consume much less. Person 1 has a higher standard of
living and person 2 has a lower standard of living than GDP per person indicates.
Uneven distribution of income is important to keep in mind when using GDP per person
as a measure of the standard of living for the typical person. However, also keep in mind that
two analyses suggest that increases in real GDP per person make the poor better off. First, as
real GDP per person for the world rose by 1.8 percent per year from 1981 to 2005, the number of
10

people living on less than $1.25 per day fell from 1.9 billion in 1981 to 1.4 billion in 2005.
1
That
represents a 26 percent decrease in the number of extremely poor individuals in just 24 years.
Even if economic growth did not cause the decrease in poverty, economic growth and substantial
decreases in poverty are compatible. Second, if all the gains from economic growth went to only
those individuals at the top of the income distribution, then increases in GDP per person would
have little benefit for those at the bottom of the income distribution. However, there is some
evidence that the poor do benefit from economic growth just as much as the rest of society.
David Dollar and Aart Kraay, economists with the World Bank, found that as real GDP per
person increased by about one percent, the income of the individuals in the bottom 20 percent of
the income distribution also increased by one percent.
2
As an economy grows, there is a
tendency for the incomes of the individuals in the bottom of the income distribution to rise.
Therefore, the rich do not get richer at the expense of the poor. Figure 5-3 shows the relationship
between the
Figure 5-3 Relationship between Real GDP per Person and Average Income of Individuals
in the Lower 20 Percent of the Income Distribution

1
Data come from the World Banks PovcalNet and are available at
http://web.worldbank.org/WBSITE/EXTERNAL/EXTDEC/EXTRESEARCH/EXTPROG
RAMS/EXTPOVRES/EXTPOVCALNET/0,,contentMDK:21867101~pagePK:64168427~pi
PK:64168435~theSitePK:5280443,00.html. Data downloaded on May 6, 2009.
2
Growth is Good for the Poor, Journal of Economic Growth vol.7, no.3, (2002) pp.195-225.
11


SOURCE: Dollar and Kraay (2002). Data is available on the web at:
http://econ.worldbank.org/WBSITE/EXTERNAL/EXTDEC/0,,contentMDK:20311740~pagePK:
64165401~piPK:64165026~theSitePK:469372,00.html#Growth__inequality_and_poverty
Caption: As real GDP per person increases, the average income for individuals in the bottom 20
percent of the income distribution also increases. On average, when real GDP per person
increases by one percentage point, the average income for individuals in the bottom 20 percent of
the income distribution also increases by about one percentage point. Therefore, there is no
tendency for inequality to increase as real GDP per person increases. We see a similar pattern
when we look at individual countries and regions such as Africa, China, Japan, the United
Kingdom and the United States.

12

End Caption
real GDP per person and average income for the bottom 20 percent of the income distribution.
As real GDP per person increases, the average income for individuals in the bottom 20 percent of
the income distribution also increases. On average, when real GDP per person increases by one
percentage point, the average income for individuals in the bottom 20 percent of the income
distribution also increases by about one percentage point. Therefore, there is no tendency for
inequality to increase as real GDP per person increases. We see a similar pattern when we look
at individual countries and regions such as Africa, China, Japan, the United Kingdom and the
United States.
Value of Leisure Time
Because real GDP per person measures the income of the average person in a country, it
tells us how many goods and services the average person can consume. But people care about
more than the goods and services they can purchase. For example, people want time to spend
with their friends, their spouses, or their children. In other words, individuals also care about
leisure time. If the large increases in the standard of living shown in Figure 5-1 came solely
from increases in labor inputs, then the increase in real GDP per person would have come at the
expense of less leisure time. Whether individuals are better off would therefore depend on the
value of the lost leisure time relative to the value of the goods and services that individuals
gained.
13

As we saw earlier, all of the increase in potential real GDP per person has come from
increased productivity and average annual hours worked per person has remained essentially
constant for the United States. Figure 5-4 shows average annual
Figure 5-4 Annual Average Hours per worker hour in Western Countries, 1870 - 2000

SOURCE: Huberman and Minns (2007).
Caption: As real GDP per person has increased, annual average hours per worker hour tends to
decrease. So, leisure time tends to rise as real GDP per person increases. Hours per year for the
average worker in the United States decreased from 3,096 hours per year in 1870 to 1,878 hours
per year in 2000. That is, a 39.3 percent decrease in the amount of time working and a
significant amount of extra time available for leisure activities such as being with friends and
14

family. All western nations experienced a similar decrease in average hours per worker hour.
For example, hours per year for the average worker in France decreased from 3,168 in 1870 to
1,443 in 2000. The decrease in hours worked was larger outside of the United States, but
average annual hours worked did decrease in the United States for reasons that we will explain in
Chapter 7.
End Caption
hours of work per worker hour for several western countries: France, Germany, Italy, the United
Kingdom, and the United States. Hours per year for the average worker in the United States
decreased from 3,096 hours per year in 1870 to 1,878 hours per year in 2000. That is, a 39.3
percent decrease in the amount of time working and a significant amount of extra time available
for leisure activities such as being with friends and family. All western nations experienced a
similar decrease in average hours per worker hour. For example, hours per year for the average
worker in France decreased from 3,168 in 1870 to 1,443 in 2000. The decrease in hours worked
was larger outside of the United States, but average annual hours worked did decrease in the
United States for reasons that we will explain in Chapter 7.
Happiness
Richard Easterlin of the University of Pennsylvania looks at results from nineteen
different countries and concludes that there is little relationship between self-reported happiness
in surveys and real GDP per person across countries or within a country.
3
This lack of

3
Does Economic Growth Improve the Human Lot? Some Empirical Evidence, (1974) In Nations and Households
in Economic Growth: Essays in Honor of Moses Abramowitz edited by Paul David and Melvin Reder. Academic
Press.
15

correlation is called the Easterlin Paradox because happiness does not necessarily increase with
incomes. Why the lack of relationship? Easterlin argues that individuals judge themselves
relative to their peer groups. Therefore, if your income increases by 10 percent, but the income
of all your peers also increases by 10 percent then you will not report yourself as any happier
because you have not improved relative to your peers. However, if your income increases by 10
percent while everyone elses income remains constant then you have improved relative to your
peers so you will report yourself as happier.
4
Because the increased real GDP per person does
not lead to increased happiness, Easterlin argues that economists and policymakers place too
much emphasis on economic growth. Richard Layard of the London School of Economics notes
that at low levels of real GDP per person an increase in income does lead to increased
happiness.
5
However, he also argues that there is little relationship between average income and
happiness once real GDP per person exceeds $15,000 per year. At low levels of income,
economic growth produces vital goods and services like food, shelter, and clothing. However,
once these basic necessities are met economic growth tends to produce luxuries that do not
necessarily make individuals better off. For example, investment bankers and lawyers often
work long hours and neglect their personal lives. They have little time to interact with spouses,
children, or friends. In this example, the extra goods and services may come at the cost of less
fulfilling personal lives. Once individuals reach a certain level of income, they begin to make
judgments about their happiness based on their income relative to their peers rather than their
absolute level of income. Therefore, an increase in income will not make a person happier if

4
Will Raising the Incomes of All Increase the Happiness of All? Journal of Economic Behavior and Organization
(1995) pp.35-47.
5
Happiness: Has Social Science a Clue? Lionel Robbins Memorial Lecture 2002/2003, London School of
Economics. Available at: http://cep.lse.ac.uk/events/lectures/layard/RL030303.pdf.
16

everyone elses income increases by just as much. Absolute income is no longer important, but
relative income is important.
The Easterlin Paradox shows that money cannot buy happiness as the saying goes. Or
does it? Justin Wolfers and Betsey Stevenson of the Wharton School at the University of
Pennsylvania reexamined this issue using a wider range of countries.
6
They find a robust
positive relationship between self-reported happiness and GDP per person across 131 countries.
In addition, Wolfers and Stevenson also find a positive relationship between economic growth
and happiness within a country. Their work suggests that economic growth and higher absolute
levels of income do make individuals happier.
Life Expectancy
Modern economic growth generates pollution. Consumers create air pollution by burning
gasoline to power their cars and natural gas to heat their homes. Firms create air pollution when
they produce electricity, pesticides, or plastics. This pollution affects the air we breathe, the
water we drink, and the food we eat. Sometimes pollution is a minor irritant that spoils scenic
views, but pollution can also contribute to dangerous diseases such as cancer. In addition, busy
workers have less leisure time, which can create stress and negative health consequences,
potentially shortening life spans. Therefore, the costs to higher real GDP per person might offset
the benefits of the increase in the amount of goods and services that individuals can purchase.
Does life expectancy decrease with real GDP per person? No. In fact, as real GDP per person

6
Economic Growth and Subjective Well-Being: Reassessing the Easterlin Paradox in Brookings Paper on Economic
Activity (Spring 2008), 1-102.
17

increases, life expectancy at birth increases suggesting that health outcomes actually improve as
real GDP per person increases. Figure 5-5 shows the relationship
Figure 5-5 Relationship between Real GDP per Person and Life Expectancy at
Birth, 2007

SOURCE: World Banks World Development Indicators
Caption: There is a clear tendency for life expectancy to increase as GDP per person increases.
When real GDP per person is $5,000 the life expectancy is 66.9 years and this rises to 74.1 years
as real GDP per person increases to $15,000. However, if real GDP per person increases by
another ten thousand dollars to $25,000 then life expectancy only increases to 77.4. Therefore,
life expectancy increases at a decreasing rate with real GDP per person. Despite the pollution
18

costs associated with economic growth, the higher real GDP per person the longer the average
person can expect to live.
End Caption
between life expectancy at birth and GDP per person for 185 countries in 2007. There is a clear
tendency for life expectancy to increase as GDP per person increases. When real GDP per
person is $5,000 the life expectancy is 66.9 years and this rises to 74.1 years as real GDP per
person increases to $15,000. However, if real GDP per person increases by another ten
thousand dollars to $25,000 then life expectancy only increases to 77.4. Therefore, life
expectancy increases at a decreasing rate with real GDP per person. Despite the pollution costs
associated with economic growth, the higher real GDP per person the longer the average person
can expect to live.
Part of the reason that pollution costs do not shorten life spans as real GDP per person
increases is that a clean environment is a normal good, which means that individuals purchase
more of it as their incomes increase. This idea lies behind the environmental Kuznets curve. The
relationship depicted by the curve states that as an economy expands, pollution initially
increases, reaches a maximum, and then begins to decline as individuals choose to spend more of
their income on a cleaner environment. Therefore, rather than destroying the environment and
reducing life expectancy, economic growth may improve the environment and increase life
expectancy. As real GDP per person increases, individuals can also purchase more health care
which should also increase life expectancy.

19

5.2 Use the Solow Growth Model to Explain the Effect of Capital Accumulation onLabor
Productivity
Labor productivity is the key determinant of real GDP per person and, therefore, the standard of
living. In Chapter 4, we learned that capital accumulation and total factor productivity (TFP) are
the primary determinants of the labor productivity. Therefore, if we want to understand why the
standard of living increases over time, we need to understand capital accumulation and the
determinants of total factor productivity. In this section, we discuss capital accumulation and
assume that total factor productivity remains constant. Economists use the Solow growth model
to explain how capital accumulation influences labor productivity. The model is named after
Nobel Laureate Robert Solow of the Massachusetts Institute of Technology who developed the
model during the 1950s.
7
His work and this model has become the foundation for how
economists think about economic growth. We work with the intensive form of the aggregate
production function that we described in Chapter 4, in which y is potential real GDP per worker
hour and k is capital per worker hour. Economists also call k the capital-labor ratio. As we saw
in Chapter 4, potential real GDP per worker hour and the capital-labor ratio are related through
the aggregate production function:
(5.2)

where is capitals share of income and A is total factor productivity. We learned in Chapter 4
that for the United States capitals share of income equals 0.32 and that total factor productivity
in 2007 was 9.4. Figure 5-6 shows:

7
Solow, Robert. A Contribution to the Theory of Economic Growth, Quarterly Journal of Economics, 70, (February
1956) pp.65-94.
20

Figure 5-6 The Aggregate Production Function for the United States, 2007

Caption: The capital-labor ratio for the United States was $144.94 per hour in 2007, and
potential real GDP per worker hour was $46.36 per hour. The production function shows us
what happens to labor productivity as the capital-labor ratio increases while keeping total factor
productivity constant. If the capital-labor ratio increases to $174.94 per hour, then labor
productivity increases to $49.24. The marginal product of the extra capital is $2.88 per hour. If
the capital-labor ratio increases again by $30 to $204.94 per hour, then labor productivity also
increases to $51.79 per hour. The marginal product of the extra capital is still positive but
decreases to $2.56 per hour. Why does the marginal product of capital decrease? The marginal
product of capital decreases due to diminishing marginal returns when total factor productivity is
constant, so the contribution of capital accumulation to labor productivity growth eventually
becomes zero. The fact that capital experiences diminishing marginal returns means that the
21

sustained increase in labor productivity and the standard of living that the United States and
other countries have experienced must be due to factors other than capital accumulation such as
total factor productivity growth. We will return to this issue later in the chapter.
End Caption
the aggregate production function for the United States. The capital-labor ratio for the United
States was $144.94 per hour in 2007, and potential real GDP per worker hour was $46.36 per
hour. The production function shows us what happens to labor productivity as the capital-labor
ratio increases while keeping total factor productivity constant. If the capital-labor ratio
increases to $174.94 per hour, then labor productivity increases to $49.24. The marginal
product of the extra capital is $2.88 per hour. If the capital-labor ratio increases again by $30 to
$204.94 per hour, then labor productivity also increases to $51.79 per hour. The marginal
product of the extra capital is still positive but decreases to $2.56 per hour. Why does the
marginal product of capital decrease? The marginal product of capital decreases due to
diminishing marginal returns when total factor productivity is constant, so the contribution of
capital accumulation to labor productivity growth eventually becomes zero. The fact that capital
experiences diminishing marginal returns means that the sustained increase in labor productivity
and the standard of living that the United States and other countries have experienced must be
due to factors other than capital accumulation such as total factor productivity growth. We will
return to this issue later in the chapter.
Capital Accumulation and the Bath Tub Analogy
22

Labor productivity is the critical determinant of the standard of living. We learned in
Chapter 4 that 41.7 percent of the labor productivity growth is due to capital accumulation. The
Solow growth model helps explain capital accumulation. If you understand a bath tub, then you
understand the essential elements of this model. Figure 5-7 shows a bath tub with water flowing
into the tub through the faucet
Figure 5-7 Capital Accumulation and the Bath Tub Analogy






Caption: Understanding the basics of capital accumulation are as simple as understanding why
the level of water rises and falls in a bath tub. Investment per worker hour is the water flowing
into the bath tub and the amount of investment necessary to keep the capital-labor ratio constant
is water flowing out of the bath tub. The level of water in the bath tub is the capital-labor ratio.
End Caption
and water flowing out of the bath tub through the drain. The level of water is a stock variable
because we measure it at a point in time, while the water flowing into and flowing out of the tub
Water flowing into the bath tub
Water flowing out of the bath tub
Level of water in the bath tub
23

are flow variables that are measured per time period. When is the level of water in the bath tub
constant? The answer is simple. The level of the water in the tub is constant when the water
flowing into the bath tub is exactly equal to the water flowing out of the bath tub. How does the
level of water in the tub change? The level of water in the tub increases when the water flowing
into the tub is greater than the water flowing out of the tub, and the level of water in the tub
decreases when the water flowing out of the tub is greater than the water flowing into the tub.
To apply the bath tub analogy to labor productivity, we just need to identify the stock and
flow variables in the Solow growth model. The capital-labor ratio is the stock variable because
we measure it at a point in time as the amount of capital goods per worker. As a reminder, the
capital-labor ratio is defined as:

,
where K is the stock of capital goods and L is the labor force. The capital-labor ratio can change
for one two reasons: either the capital stock changes or labor force changes.
Investment and Water Flowing into the Bath Tub
The level of water in the bath tub increases when water flows into the tub, but what
causes the capital-labor ratio to increase? The capital-labor ratio increases when the stock of
machines, tools, buildings, and roads increases. In other words, when households, firms, or the
government purchase investment goods. For simplicity, we assume that the investment rate of
for the economy, s, is a constant ratio between zero and one. Investment per worker hour, i,
equals:
(5.3) .
24

Figure 5-8 shows the investment rate for the United States from 1949 to 2008. During this
Figure 5-8 The Investment Rate for the United States, 1949 - 2008

SOURCE: Bureau of Economic Analysis and Congressional Budget Office
Caption: the private sector conducts the vast majority of investment activity in the United
States. From 1949 to 2008, private sector investment averaged 16.0 percent of potential GDP
while government investment averaged just 4.1 percent of potential real GDP. You should also
notice a distinct decrease in the rate of government investment after the 1960s, from 6.5 percent
in 1953 to 3.4 percent in 2008.
End Caption
period, the investment rate averaged 0.201 of potential GDP, so:
25

i = 0.201y
for the United States. Figure 5-9 shows that the private sector conducts the vast majority of
investment activity in the United States. From 1949 to 2008, private sector investment averaged
16.0 percent of potential GDP while government investment averaged just 4.1 percent of
potential real GDP. You should also notice a distinct decrease in the rate of government
investment after the 1960s, from 6.5 percent in 1953 to 3.4 percent in 2008. Remember that

, so:
(

), and
for the United States,
()(

.
Figure 5-9 shows how investment per worker hour changes as the capital-labor ratio increases.
Figure 5-9 Investment per worker hour, Real GDP per worker hour, and the Capital-
Labor Ratio
26


Caption: Notice that the investment function has the same general shape as the production
function from Figure 4.6 (a) in Chapter 4. This similarity occurs because we have assumed a
constant investment rate for the economy. Therefore, as the capital-labor ratio increases real
GDP per worker hour also increases and that causes investment per worker hour to increase.
However, because of diminishing marginal returns, the increase in investment per worker hour
gets smaller and smaller as the capital-labor ratio increases.

End Caption
Notice that the investment function has the same general shape as the production function from
Figure 4.6 (a) in Chapter 4. This similarity occurs because we have assumed a constant
investment rate for the economy. Therefore, as the capital-labor ratio increases real GDP per
27

worker hour also increases and that causes investment per worker hour to increase. However,
because of diminishing marginal returns, the increase in investment per worker hour gets smaller
and smaller as the capital-labor ratio increases.
The Role of the Financial Sector in Capital Accumulation
Capital accumulation plays an important role in explaining labor productivity. But how
do households, firms, and the government finance the purchase of new capital goods? This
question highlights the importance of the financial sector because investment is often financed
by funds obtained in financial markets. If Ford wants to build a new factory in the United States,
then it is likely to obtain the funds in financial market by either borrowing or issuing new stock.
Where do financial markets obtain the funds to finance Fords investment? Other individuals in
the household, government, and foreign sectors have decided to save. When you save by putting
some of your income in a savings account, this saving allows the bank to lend those funds toa
household or a firm, like Ford, that wants to invest. Therefore, a well functioning financial
market is essential for allowing households, firms, and the government to finance the investment
expenditures that lead to higher labor productivity.
Investment is the purchase of capital goods by households and firms,

, and the
government,

. Therefore, the total amount of capital goods purchased in an

economy, I, is:

.
28

The funds for purchasing these investment goods come from private savings,

,
government savings,

, and foreign sector savings,

. Therefore, national
savings, S, is:

.
Private saving equals household disposable income minus consumption expenditures. Therefore,
a tax increase, a decrease in income, or an increase in consumption all lead to less private
savings. If government saving is positive then the government runs a budget surplus, but if
government saving is negative then the government runs a budget deficit. A budget surplus, like
the United States had in the late 1990s, leads to higher national saving, all else equal. In
contrast, the large budget deficits that the government expects to run from 2010 to 2019 means
that national saving is lower. Foreign sector saving is the sum of saving by foreign households
and foreign governments. When individuals in these sectors save, then there is a larger pool of
funds available to finance investment expenditures.
When we discussed the loanable funds model in Chapter 3, we learned that saving equals
investment, so:
,
and

.
The results here are very similar to the results with the loanable funds model in Chapter 3. A
budget deficit means government savings becomes negative. Unless private or foreign savings
29

increases to compensate, investment expenditures must decrease. Whether the budget deficit
causes private or government investment expenditures to decrease depends on the circumstances.
Similarly, if the household sector saves more and government and foreign savings remain
constant, then investment expenditures must increase. Again, whether private or government
investment expenditures increase depends on the circumstances.
Break-Even Investment and Water Flowing out of the Bath Tub
Break-even investment is the level of investment necessary to keep the capital-labor ratio
constant. When investment is greater than the break-even level, the capital-labor ratio increases
and when investment is less than the break-even level, the capital-labor ratio decreases. Two
factors determine the break-even level of investment. First, the capital stock depreciates over
time. We assume that the depreciation rate, d, is a constant fraction of the capital-labor ratio and
that the depreciation rate is between zero and one, so:
.
Second, the capital-labor ratio can decrease when the capital stock is constant and the number of
workers increases. The capital-labor ratio decreases because the existing capital stock is spread
across a larger labor force. You can think of this as the dilution of the existing capital stock. We
use n to represent the growth rate of the labor force and n takes a value between zero and one, so:
.
Therefore, we can think of break-even investment as:
(5.4)
30

( ).
Notice that break-even investment is just a constant fraction of the capital-labor ratio, so at
higher levels of the capital-labor ratio the break-even investment is higher. For the United
States, the growth rate of potential labor hours has averaged 1.2 percent or 0.012 per year from
1949 - 2008. The depreciation rate depends on the type of capital good. For example, buildings
can last for decades while computers may only be useful for a few years so computers depreciate
much more quickly than buildings. However, a depreciation rate of 10 percent or 0.10 is a
common value to use. Hence, break-even investment for the United States is:
Break-Even Investment = (0.10 + 0.012)k = 0.112k.
When we graph the break-even investment line in Figure 5-10, we see that it is a straight line
with
Figure 5-10 Break-Even Investment and the Capital-Labor Ratio
31


Caption: The break-even investment line has a slope equal to the sum of the depreciation rate
and the labor force growth rate. At higher levels of the capital-labor ratio, more investment is
required to keep the capital-labor ratio constant, so the break-even level of investment is also
higher. An increase in the depreciation or labor force growth rates leads to a steeper break-even
investment line, while a decrease in the depreciation rate or labor force growth rates leads to a
flatter break-even investment line.
End Caption
a positive slope equal to (d + n); at higher levels of the capital-labor ratio, more investment is
required to keep the capital-labor ratio constant, so the break-even level of investment is also
higher. An increase in the depreciation or labor force growth rates leads to a steeper break-even
investment line, while a decrease in the depreciation rate or labor force growth rates leads to a
flatter break-even investment line.
32

Equilibrium and the Steady State
The change in the level of water in the bath tub equals the water flowing into the bath tub
minus the water flowing out of the bath tub. For the level of water in the bath tub to remain
constant, the water flowing into the tub must equal the water flowing out of the tub. Think of
this as the equilibrium for the bath tub. In terms of the Solow growth model, the level of water is
the capital-labor ratio so equilibrium occurs when the capital-labor ratio is constant. Economists
call this equilibrium a steady state. A steady state is an equilibrium in which the capital-labor
ratio and output per worker hour are constant, but capital, labor, and output are growing. The
steady-state is the long-run equilibrium so if an economy is not at the steady-state then the
economy will gradually move toward the steady state. To find the steady state, we first need to
find an equation for the change in the capital-labor ratio and the change in the capital-labor ratio
equals investment minus break-even investment:

.
We can express this relationship as,
( ).
If we plug in the relationship for investment per worker hour in equation (5.4) we get
(5.5) ( ) (

) ( ).
Equation (5.14) is the key equation for the Solow growth model because it tells us how the
capital-labor ratio evolves over time and allows us to determine the equilibrium. We know that
33

in the steady state. We can plug this fact into equation (5.10) to solve for the steady-
state capital-labor ratio k* as:
(5.6)

()

.
Using the aggregate production function, the steady state real GDP per worker hour is:
(5.7)

()

()

.
For the United States, the formula for the steady state values is

and

.
(MD: Steady State An equilibrium in which the capital-labor ratio and output per worker hour
are constant, but capital, labor, and output are growing. The steady-state is the long-run
equilibrium so if an economy is not at the steady-state then the economy will gradually move
toward the steady state.)
Figure 5-11 shows both the investment and break-even
Figure 5-11 Equilibrium in the Solow Growth Model
34


Caption: The investment curve and the break-even investment line intersect at point A. In the
steady state, the capital-labor ratio is constant, so that the change in the capital-labor ratio is zero.
This point occurs where the investment line intersects the break-even investment line at point A
in Figure 5-12. At point A, the capital-labor ratio is $63.8 per worker hour and the levels of
investment and break-even investment are $7.1 per worker hour. Suppose that the initial capital-
labor ratio is $22 per worker hour which we label as

in Figure 5-12. At that capital-labor

ratio, the level of investment,

, is $5.1 per worker hour and is greater than break-even

investment, ( )

, of $2.5 per worker hour. According to equation (5.8), and the

capital-labor ratio increases toward the steady state capital-labor ratio,

. Now suppose the

initial capital-labor ratio is $125 per worker hour which we label as

in Figure 5-12. At that

capital-labor ratio, the level of investment,

, is $8.9 per worker hour and is greater than break-

35

even investment, ( )

, of $14.0 per worker hour. According to equation (5.8),

and the capital-labor ratio decreases toward the steady-state capital-labor ratio,

.
End Caption
investment lines. In the steady state, the capital-labor ratio is constant, so that the change in the
capital-labor ratio is zero. This point occurs where the investment line intersects the break-even
investment line at point A in Figure 5-12. At point A, the capital-labor ratio is $63.8 per worker
hour and the levels of investment and break-even investment are $7.1 per worker hour.
The steady state at point A is stable because there is a built-in tendency for the economy
to move toward the equilibrium. For example, suppose that the initial capital-labor ratio is $22
per worker hour which we label as

in Figure 5-12. At that capital-labor ratio, the level of

investment,

, is $5.1 per worker hour and is greater than break-even investment, ( )

, of
$2.5 per worker hour. According to equation (5.8), and the capital-labor ratio increases
toward the steady state capital-labor ratio,

. The increase in the capital-labor ratio is the

vertical distance between the investment and break-even investment lines. Notice that this
vertical distance decreases as the capital-labor ratio increases. Why does this happen? As the
economy accumulates more capital goods per worker hour, capital goods become less productive
because of diminishing marginal returns. As a result, the extra output and investment that the
economy receives from additional capital decreases as the economy accumulates more capital.
The increase in the capital-labor ratio continues until and that does not occur until the
capital-labor ratio equals

.
36

Now suppose the initial capital-labor ratio is $125 per worker hour which we label as

in Figure 5-12. At that capital-labor ratio, the level of investment,

, is $8.9 per worker hour

and is greater than break-even investment, ( )

, of $14.0 per worker hour. According to

equation (5.8), and the capital-labor ratio decreases toward the steady-state capital-labor
ratio,

. The decrease in the capital-labor ratio is the vertical distance between the investment
and break-even investment lines. Notice that this vertical distance decreases as the capital-labor
ratio decreases due to diminishing marginal returns. Why does this happen? Once again it is due
to diminishing marginal returns. As the economy reduces capital goods per worker hour, capital
goods become more productive. As a result, the extra output and investment that the economy
receives from additional capital increases as the economy reduces the capital-labor ratio. The
decrease in the capital-labor ratio continues until and that does not occur until the
capital-labor ratio equals

. So, the steady-state is the equilibrium for the economy. We will

come back to this point when we discuss the balanced growth path in the next section.
The Investment Rate and Real GDP Per Worker Hour
Now that we have an equilibrium model for the capital-labor ratio and real GDP per
worker hour, we can ask what causes the equilibrium to change. Figure 5-12 shows what
happens when the investment rate increases from 0.201,

, to 0.302,

. First,
Figure 5-12 An Increase in the Investment Rate
37


Caption: An increase in the investment rate from 0.201 to 0.302 shifts the investment curve
shifts upward from

to

, so the economy is now producing more investment goods for any

given level of the capital-labor ratio. Next, the capital-labor ratio increases. The level of
investment is now greater than the level necessary to replace depreciation and provide the new
workers with just as much capital as the existing workers. As a result, the capital-labor ratio
begins to rise from the original steady-state value of $63.8,

, to the new steady-state value of

$115.8,

. Because the capital-labor ratio is one of the inputs of the production function, the
higher capital-labor ratio increases real GDP per worker-hour. So, the Solow growth model
predicts that a higher investment rate will increase labor productivity from $35.5 dollars per
worker hour,

, to $43.0 dollars per worker hour,

, and a higher standard of living. Notice

that the increase in real GDP per worker hour eventually decreases to zero due to diminishing
marginal returns to capital goods.
38


End Caption
the investment curve shifts upward from

to

, so the economy is now producing more

investment goods for any given level of the capital-labor ratio. Next, the capital-labor ratio
increases. The level of investment is now greater than the level necessary to replace depreciation
and provide the new workers with just as much capital as the existing workers. As a result, the
capital-labor ratio begins to rise from the original steady-state value of $63.8,

, to the new
steady-state value of $115.8,

. Because the capital-labor ratio is one of the inputs of the

production function, the higher capital-labor ratio increases real GDP per worker-hour. So, the
Solow growth model predicts that a higher investment rate will increase labor productivity from
$35.5 dollars per worker hour,

, to $43.0 dollars per worker hour,

, and a higher standard of

living. Notice that the increase in real GDP per worker hour eventually decreases to zero due to
diminishing marginal returns to capital goods.
[Box Begins]
Macro Data: The American Reinvestment and Recovery Act and Real GDP Per Person
Congress passed and President Obama signed into law the American Reinvestment and Recovery
Act in February 2009. The Act is designed to stimulate the economy in the short run, but it may
have a negative long-run effect on labor productivity and the standard of living. The
Congressional Budget Office estimates that the Act will reduce real GDP by between 0.0 percent
39

and 0.2 percent in 2019.
8
Why is that? The Act will increase the budget deficit by $787 billion
dollars, which the government is likely to pay for by borrowing. In other words, the government
will run a budget deficit and government savings will decrease. Because investment
expenditures equal saving, the investment rate should fall and the decrease in the investment rate
should lead to a lower capital-labor ratio and a lower level of potential real GDP per worker
hour. Figure 5-13 shows the effect of the decrease in the investment due to the borrowing
Figure 5-13 The Long-Run Effect of the American Reinvestment and Recovery Act


8
Estimated Macroeconomic Impacts of the American Recovery and Reinvestment Act of 2009. Letter from
Douglas Elmendorf Director of the Congressional Budget Office to Senator Charles E. Grassley (Iowa). March 2,
2009. Available at: http://www.cbo.gov/ftpdocs/100xx/doc10008/03-02-Macro_Effects_of_ARRA.pdf.
40

Caption: The budget deficits will reduce government savings which will reduce the funds
available to the private sector to invest. As a result the investment rate will decrease from s
1
to s
2

and the investment curve will shift downward from s
1
y to s
2
y. As a result, the steady-state
capital-labor ratio will decrease from

to

and output per worker hour will decrease from

to

. Because workers will be less productive, potential real GDP will also decrease.
End Caption
associated with the American Reinvestment and Recovery Act. The budget deficits will reduce
government savings which will reduce the funds available to the private sector to invest. As a
result the investment rate will decrease from s
1
to s
2
and the investment curve will shift
downward from s
1
y to s
2
y. As a result, the steady-state capital-labor ratio will decrease from

to

and output per worker hour will decrease from

to

. Because workers will be less

productive, potential real GDP will also decrease. However, part of the funds from the Act will
go to infrastructure and other investment projects for which the government is responsible. If
the Act adds government investment dollars to balance off falling private investment dollars, the
overall investment rate in the economy, and the investment curve, will shift down only slightly.
The end result will be a relatively small decrease in potential real GDP per worker hour and
potential real GDP. However, if the Act finances government consumption or investment
projects with little or no value, then the investment rate for the economy will decrease and so
will labor productivity and potential real GDP. The key point is that a deficit may reduce
potential real GDP depending upon what the government does with the funds it borrows.
See related problem XXX on page XXX.
41

[End Box]
Depreciation, Labor Force Growth Rate, and Real GDP per worker hour
Figure 5-14 shows what happens when the depreciation rate decreases. First, the break-
Figure 5-14 A Decrease in the Depreciation Rate

Caption: A decrease in the depreciation rate flattens the break-even investment line. Next, the
capital-labor ratio increases for the same reason as we found when the investment rate increases;
the level of investment is now greater than the level necessary to replace depreciation and
provide the new workers with just as much capital as the existing workers. As a result, the
capital-labor ratio begins to rise from the original steady-state value of

to the new steady-state

value of

. Because the capital-labor ratio is one of the inputs of the production function, the
higher capital-labor ratio increases potential real GDP per worker hour. Therefore, the Solow
42

growth model predicts that a lower depreciation rate will lead to higher productivity and higher
standard of living.
End Caption
even investment line flattens. Next, the capital-labor ratio increases for the same reason as we
found when the investment rate increases; the level of investment is now greater than the level
necessary to replace depreciation and provide the new workers with just as much capital as the
existing workers. As a result, the capital-labor ratio begins to rise from the original steady-state
value of

to the new steady-state value of

. Because the capital-labor ratio is one of the

inputs of the production function, the higher capital-labor ratio increases potential real GDP per
worker hour. Therefore, the Solow growth model predicts that a lower depreciation rate will
lead to higher productivity and higher standard of living.
What about the growth rate of the labor force? Notice that the growth rate of the labor
force and the depreciation rate both influence the slope of the break-even investment line in the
same way. Therefore, a decrease in the labor force growth rate will have exactly the same effect
on the standard of living as a decrease in the depreciation rate. Therefore, the Solow growth
model predicts that a lower labor force growth rate will lead to higher productivity and higher
standard of living.

Solved Problem 5.1: A Decrease in the Labor Force Growth Rate and Real GDP per
worker hour. According to the United Nations Population Division, the population growth rate
43

averaged 1.7 percent per year between 1950 and 2005. The following table shows the
Population Division forecasts that the population growth rates for different regions in the world.
Population Growth Rates across the World
Period Africa Asia Europe North
America
South
America
World
1950 to 2005 2.6 1.9 0.5 2.2 1.2 1.7
2005 to 2050 1.7 0.6 -0.1 0.6 0.6 0.8

Change in the
Population
Growth Rate
-0.9 -1.3 -0.6 -1.6 -0.6


-0.9
SOURCE: United Nations Population Division. The calculations are based upon the Median
Variant forecast.
The slower population growth rate should also reduce the growth rate of the labor force. What
effect will this reduction have on labor productivity and the standard of living in the world?

Solving the Problem:
Step 1: Review the chapter material. The problem asks you to determine the effect of a
decrease in the labor force growth rate on labor productivity and the standard of living, so you
may want to review the section Depreciation, Labor Force Growth Rate, and Real GDP per
worker hour, which begins on page x.

44

Step 2: Use a graph to determine how a decrease in labor force growth rate influences the
Solow growth model.
The Solow growth model consists of three curves: the aggregate production function, the
investment curve, and the break-even investment line. To determine the effect of a decrease in
the labor force growth rate, we must determine which, if any, of these curves the labor force
growth rate influences. Earlier we learned that the break-even investment line is ( ) so the
slope of the break-even investment depends on the depreciation rate and the labor force growth
rate. When the labor force growth rate decreases, the slope of the break-even investment line
will decrease and the line will flatten or pivot downwards. The equation for the aggregate
production function is

and equation the equation for the investment curve is then you
will see so that the labor force growth rate does not influence either of these curves. Therefore,
the labor force growth rate influences only break-even investment. Your graph showing the
effect of the decrease in the labor force growth rate should look like this:

45


Step 3: Determine the effect on the capital-labor ratio. The break-even investment line shifts
downwards. At the initial capital-labor ratio,

, the level of investment,

is greater than the

new level of break-even investment, (

. Equation (5.14) tells us how the capital-labor

ratio evolves over time. Using that equation and what we know about the current levels of
investment and break-even investment:

.
As a result, the capital-labor ratio begins to increase towards the new steady-state capital-labor
ratio,

. The change in the capital-labor ratio is the vertical distance between the investment
curve and the break-even investment line. The vertical distance gets smaller as the capital-labor
ratio increases due to diminishing marginal returns, so the increase in the capital-labor ratio gets
46

smaller and smaller as the world approaches the new steady state. Growth stops when the
economy reaches the new steady state at point B. The steady state level of labor productivity has
increased from

to

.

Step 4: Determine the effect of the capital-labor ratio on the standard of living. Economists
use real GDP per person to measure the standard of living, and equation (5.1) tells us that real
GDP per person equals labor productivity multiplied by labor input. We measure labor input as
average annual hours worked per person. If labor input remains constant, then the increase in
labor productivity from

to

will increase the standard of living. The ultimate effect of the

decrease in the population growth rate is to increase the standard of living for the average person
in the world.
The United Nations predicts that the population growth rate will decrease during the 2005
to 2050 period for all regions of the world. However, the table at the beginning of this Solved
Problems shows that the decrease in the population growth rate will vary across regions of the
world. For example, Africa is expected to have a population growth rate of 1.7 percent per year.
Asia, North America, and South America are expected to have population growth rates of about
0.6 percent per year, but Europe is expected to have a negative population growth rate of -0.1
percent per year. The largest decrease in the population growth rate will occur in North America
so, all else equal, you should expect that labor productivity and the standard of living increases
from slower labor force growth rates will be highest in North America.

47

Your Turn: See related problem XXX on page XXX.
**********************************************************************
Table 5-3 summarizes how changes in the Solow growth model change the steady-state
Table 5-3 Summary of Changes in the Steady-State
An increase in will leading to and
the investment rate shift the investment
curve up
an increase in the
capital-labor ratio
increase potential real
GDP per worker hour.
the level of total
factor productivity

shift the investment
curve up
an increase in the
capital-labor ratio
increase potential real
GDP per worker hour.
the depreciation
rate
shift the break-even
investment live up
a decrease in the
capital-labor ratio
a decrease in potential
real GDP per worker
hour.
the labor force
growth rate
shift the break-even
investment live up
a decrease in the
capital-labor ratio
a decrease in potential
real GDP per worker
hour.

potential real GDP per worker hour. Increases in the investment rate and total factor productivity
lead to higher real GDP per worker hour in the steady-state while increases in the depreciation
rate and the growth rate of the labor force lead to lower real GDP per worker hour in the steady
state.

5.3 Explain how Total Factor Productivity Affects Labor Productivity
48

Total factor productivity measures the overall efficiency of the economy in transforming capital
and labor into final goods and services that households can consume. Total factor productivity
growth, along with capital accumulation are the two sources for increases in labor productivity.
We just learned that increases in labor productivity from capital accumulation eventually
decrease to zero due to diminishing marginal returns. As a consequence, total factor productivity
is the ultimate source of labor productivity growth and, hence, the increase in the standard of
living.
Total Factor Productivity and Real GDP per worker hour
Figure 5-15 shows the effect of an increase in total factor productivity for the United
Figure 5-15 An Increase in Total Factor Productivity

49

Caption: For the United States in 2007, total factor productivity is initially 9.4 and the capital-
labor ratio is $144.9 per hour so potential real GDP per worker hour is $46.4 and the economy is
at point A in Figure 5-16. If the capital-labor ratio remains constant and total factor productivity
increases by one point to 10.4 then the production function shifts up and the economy is now at
point B, so that at any given capital-labor ratio, real GDP per worker hour increases to $51.3 per
hour. In this example, an increase in total factor productivity has a similar effect as an increase
in the investment rate. But there is an important difference. The marginal product of capital
decreases as the economy accumulates more capital holding all else constant, but the extra output
from increasing total factor productivity does not. If total factor productivity increases to by
another point to 11.4 then the economy moves to point C and potential real GDP per worker hour
increases to $56.2. Therefore, each time total factor productivity increases by one point,
potential real GDP per worker hour increases by $4.9. In contrast to capital goods, there are no
diminishing marginal returns for total factor productivity. Therefore, there is no limit to growth
from increases in total factor productivity and total factor productivity growth must be the
explanation for increases in labor productivity and the standard of living.
End Caption
States in 2007 assuming that the capital-labor ratio equals $144.9 per hour. Total factor
productivity is initially 9.4 so potential real GDP per worker hour is $46.4 and the economy is at
point A in Figure 5-16. If the capital-labor ratio remains constant and total factor productivity
increases by one point to 10.4 then the production function shifts up and the economy is now at
point B, so that at any given capital-labor ratio, real GDP per worker hour increases to $51.3 per
hour. In this example, an increase in total factor productivity has a similar effect as an increase
50

in the investment rate. But there is an important difference. The marginal product of capital
decreases as the economy accumulates more capital holding all else constant, but the extra output
from increasing total factor productivity does not. If total factor productivity increases to by
another point to 11.4 then the economy moves to point C and potential real GDP per worker hour
increases to $56.2. Therefore, each time total factor productivity increases by one point,
potential real GDP per worker hour increases by $4.9. In contrast to capital goods, there are no
diminishing marginal returns for total factor productivity. Therefore, there is no limit to growth
from increases in total factor productivity and total factor productivity growth must be the
explanation for increases in labor productivity and the standard of living.
New technology is one source of higher total factor productivity. If a new technology is
discovered that increases the processing power of computers, then total factor productivity would
increase from A
1
to A
2
. The production function would shift upward and real GDP per worker
hour would increase. Similarly, if a second technology is discovered that reduces congestion on
the internet, then the productivity of all existing computers would increase so total factor
productivity would increase from A
2
to A
3
. The production function would again pivot upward
and real GDP per worker hour would increase again.
What effect does an increase in total factor productivity have on the steady-state values of
the capital-labor ratio and potential real GDP per worker hour? Figure 5-16 shows the effect of a
one-time
Figure 5-16 A One-Time Increase in Total Factor Productivity
51


Caption: The one-time increase in total factor productivity shifts the production function from

to

. At the initial capital-labor ratio, investment,

, is now greater than

break-even investment. As a result, the capital-labor ratio increases and this causes potential real
GDP per worker hour to increase and the steady state to move from point A to point B.
End Caption
increase in total factor productivity. The one-time increase in total factor productivity shifts the
production function from

to

. At the initial capital-labor ratio, investment,

, is now greater than break-even investment. As a result, the capital-labor ratio

increases and this causes potential real GDP per worker hour to increase and the steady state to
move from point A to point B.
52

In fact, the growth rate of total factor productivity, g
A
, is the key determinant for labor
productivity growth and the growth rate of the standard of living when labor inputs per person
are constant. Table 5-4
Table 5-4 Steady-State Growth Rates
Variable Symbol Steady-State Growth Rate
Capital-labor ratio

Potential real GDP per worker hour

Capital Stock
(

Potential real GDP
(

shows the steady-state growth rates for the capital-labor ratio and potential real GDP per worker
hour when the hours per person (labor input) is constant. The appendix at the end of the chapter
shows the how to derive the steady-state growth rates. For the United States, capitals share of
income, , is 0.32. TFP growth has averaged 0.0125 or 1.25 percent per year and the growth rate
of potential labor hours, n, averaged 0.0121 or 1.21 percent per year. So, for the United States:

) or 1.84 percent per year,

and

) or 3.05 percent per year.

53

Labor productivity increases by about 1.84 percent per year, and if labor inputs per person are
constant, then potential real GDP per person also grows at about 1.84 percent per year.
Similarly, when labor inputs per person are constant, potential labor hours grow at about 1.21
percent per year so potential real GDP grows at about 3.05 percent per year.
What Explains Differences in TFP?
Now that we know that TFP growth is the key factor behind labor productivity growth
and the growth rate of the standard of living, we need to determine why TFP increases over time.
Economists have spent a tremendous amount of time trying to answer this question. Although no
single theory has emerged, economists have identified several important factors, which we
discuss next.
Research and Development and the Level of Technology
As we mentioned in Chapter 4, total factor productivity measures the overall efficiency of
the economy in transforming inputs into real GDP. One of the most important factors
influencing total factor productivity is the stock of knowledge that the world possess and the
associated level of technology. The invention of computers made workers more productive by
giving them new and better types of capital goods to work with. For example, word processors
allow one administrative assistant today to do work that would have taken a team of
administrative assistants in 1949. Assembly line workers in automobile plants now operate and
oversee robots rather than doing the manual labor themselves. As a result, one worker today can
produce many more automobiles than a team of workers could in 1949. In both examples, the
new capital goods has made labor more productive.
54

New capital goods do not just appear out of thin air. Private firms and the government
devote a significant amount of resources to research and development (R&D) activities to come
up with ideas for new capital goods or new goods and services for consumption. A considerable
amount of the economys resources are devoted to discovering and testing these new ideas. The
Commerce Department calculates that the United States conducted $317 billion worth of R&D in
2004, with the private sector responsible for $209 billion of R&D and the government
responsible for the remaining $108 billion of R&D.
[Begin Box]
Research and Development Expenditures and Labor Productivity Differences between
China and the United States
On page xx we saw that labor productivity in the United States was 6.3 times higher than in
China. Because of the higher labor productivity, the United States is able to maintain a higher
standard of living. Part of the reason the United States has a higher level of labor productivity is
that the United States devotes more resources to develop new technology and accumulate human
capital. For example, in 2004 (the most recent year data is available for both countries) the
United States devoted 2.6 percent of GDP to research and development while China devoted just
1.2 percent and as recently as 1996 China devoted just 0.6 percent of GDP research and
development. The higher level of investment in new technology helps increase knowledge and
total factor productivity so U.S. workers remain more productive.
SOURCE: World Development Indicators, the World Bank.
[End Box]
55


H3: Quality of Labor
The quality of labor, like the quality of capital goods, can change over time. Workers
become more skilled as they acquire human capital. Human capital is the accumulated
knowledge and skills that workers acquire from education and training or from life experiences.
There are two basic ways for workers to acquire human capital.
(MD: Human Capital The accumulated knowledge and skills that workers acquire from
education and training or from life experiences.)
First, a worker can go to school for formal training to learn basic skills that are useful in
the workplace. Students go to school to learn science, math, and other subjects that make them
better workers. And as students learn and acquire new skills, their human capital increases, and
they become more productive workers. Through this learning, education transforms low-skilled
high school graduates into high-skilled engineers and scientists.
Second, as Nobel Laureate Kenneth Arrow of Stanford University points out, workers
can accumulate skills through learning by doing.
9
Arrow argued that the more workers perform
a task, the more they learn about how to do the task quickly thereby improving their
productivity in doing the task. Arrow cited evidence from engineering studies showing that the
amount of time it takes to build an airplane decreases as workers build more airplanes. This
relationship emerges because the workers have acquired knowledge and skills through building
the previous airplanes, making them more productive.

9
Economic Implications of Learning by Doing, The Review of Economic Studies (June 1962), pp.155-173.
56

H3: Government and Social Institutions
Nobel Laureate Douglass North of Stanford University and economist Robert Thomas of
the University of Washington have emphasized the importance of government and social
institutions in explaining differences in labor productivity and the standard of living across
countries.
10
North and Thomas, and many other economists, believe that markets and property
rights are important institutions that lead to economic growth. Individuals and firms are unlikely
to risk their own funds, and investors are unlikely to lend their funds to individuals and firms,
unless they can keep the profits from risky investment projects. In other words, property rights
must be secure to encourage investment and capital accumulation. In some countries, property
rights are not secure due to government corruption because it is impossible for individuals and
firms to start or expand businesses without paying bribes to at least one government official.
Historical evidence suggests that government institutions and property rights do matter.
After Germanys defeat in World War II and the onset of the Cold War between the United
States and the Soviet Union, Germany was divided into West Germany which was a
parliamentary democracy with a market economy and secure property rights and East Germany
which was a communist dictatorship without a strong market or secure property rights. Both
East and West Germany were devastated by World War II. The two countries were reunified
into a single country in 1990 and at the time of reunification real GDP per person in then West
Germany was 2.6 times the level of real GDP per person in East Germany. The case of North
and South Korea provides a second example of the importance of government institutions. Japan
had occupied the Korean peninsula during World War II, but after Japans surrender Soviet

10
The Rise of the Western World: A New Economic History. Cambridge University Press (1973).
57

troops occupied what would become North Korea while U.S. troops occupied what would
become South Korea. Just like East Germany, North Korea was a communist dictatorship
without strong markets or secure property rights while South Korea had strong markets and
secure property rights. While economic data for North Korea are unreliable because the North
Korean government does not make official data available, the CIA Fact Book estimates that real
GDP per person for South Korea was 14.4 times the level in North Korea in 2008.
Economists Daron Acemoglu of MIT, Simon Johnson of MIT, and James Robinson of
the University of California at Berkeley tried to find systematic evidence showing the effect of
government and social institutions on real GDP per person.
11
European countries colonized large
regions of the world between the 1600s and the 1800s. In countries such as the United States,
Australia and New Zealand, Europeans came as settlers and established institutions that enforced
the rule of law. These favorable institutions encouraged investment which led to faster economic
growth and higher real GDP per person. However, in Africa and other areas European countries
did not come as settlers. Instead, the Europeans came to extract natural resources and so did not
establish government institutions that favored investment. The areas of the world in which the
Europeans established strong property rights are generally rich today while the regions in which
Europeans did not establish strong property rights are generally not rich.
The experiences of the Germany, Korea, and the former European colonies have
convinced many economists that government institutions play a critical role in encouraging
economic growth.

11
The Colonial Origins of Comparative Development: An Empirical Investigation, American Economic Review
(December 2001), pp. 1369-1401.
58

Geography
Not all economists today agree with the primary importance of institutions for explaining
the standard of living. In fact, as long ago as Adam Smiths 1776 book An Inquiry into the
Nature and Causes of the Wealth of Nations, economists have pointed out that geography
influences a nations natural resources. For example, access to navigable rivers and coast line
makes trade easier and should increase labor productivity and the standard of living. For
example, the United States has a large coast line and extensive navigable rivers while countries
such as Bolivia and Tibet are landlocked and mountainous so transportation is difficult.
However, Jeffrey Sachs of Columbia University argues that geography plays an important role in
economic growth for another reason. Sachs, along with economists Andrew Mellinger and John
Gallup, argues that tropical climates experience higher rates of infectious disease such as
malaria.
12
The countries that are poor today are often the countries with high rates of infectious
disease, such as malaria, in the past. Infectious disease influence health especially for infants
and young children, and these health problems can influence the labor productivity later in life.
For example, children with serious childhood illnesses often grow up to be shorter than other
children. If someone is short due to extensive childhood illness or nutritional deficiency as a
child then they are often not as physically strong as they otherwise would have been. As a result,
workers who are shorter due to physical illness often make them less productive agricultural
workers. This adverse link may explain why agricultural productivity is lower in tropical areas,
such as Burundi, Malawi, Uganda and Zambia. Low agricultural productivity makes famines

12
Climate, Coastal Proximity, and Development, in Oxford Handbook of Economic Geography. Oxford University
Press (2000).
59

more likely, with a further negative effect on health, labor productivity, and the standard of
living.
The Financial System
The role of the financial system is to match borrowers with lenders and so the financial
system helps the economy allocate resources. When the financial system works well, individuals
who want to borrow to finance the accumulation of physical or human capital can find someone
willing to lend them funds. To the extent that firms and the government fund R&D with funds
obtained in the financial system, a well-functioning financial system also supports R&D
activities and can therefore lead to more investment in physical capital, human capital, and R&D.
The financial system can also influence the efficiency of the economy, which means can
influence total factor productivity. The financial system allocates funds to the individuals who
are willing to pay the most to obtain the funds in the form of interest. These individuals are also
those whose investment projects have the best likelihood of success. Therefore, a good financial
system ensures that resources flow to their most productive uses, and total factor productivity for
the economy increases. As a consequence, labor productivity and the standard of living are
higher.
Research by Thorsten Beck of the World Bank, Ross Levine of the University of
Minnesota, and Norman Loayza of Central Bank of Chile concludes that the financial system
does have a significant effect on total factor productivity growth.
13
Interestingly, it is not just
banks that matter for economic growth. Ross Levine and Sara Zervos of the World Bank find

13
Finance and the Sources of Growth, Journal of Financial Economics (2000) pp. 261-300.
60

that stock market liquidity also influences productivity and capital accumulation.
14
The more
liquid a stock market, the easier it is for investors to sell stocks in a company that they no longer
want. Because stocks are easier to sell when people do not want to hold them, they are more
likely to purchase the stock in the first place. As a consequence, stock prices are higher, and it is
less costly for firms to issue new stock to pay for investment projects. The research by Ross
Levine and others on financial markets tells us that the development of financial markets plays
an important role in sustaining economic growth in both developed and developing economies.
[Begin Box]
Chinese Economic Reforms of 1978
Economic research and history tells us that government institutions are important determinants of
economic growth and the standard of living. Figure 5-1 on page xx shows that economic growth
accelerated in China starting in the late 1970s at about the time that China instituted a number of
major economic reforms in 1978. Prior to the reforms China was a communist nation without
secure property rights so markets in China were relatively limited and unimportant. For
example, agricultural workers had to turn over everything that they produced to the Chinese
government which then distributed the food to its citizens. The Chinese government also placed
severe restrictions on foreign firms and individuals that wanted to purchase financial assets or
physical assets in China. The economic reforms changed this. The initial reforms opened China
to international trade and investment which allowed foreign technology to flow into China more
easily and so should have increased total factor productivity. The initial reforms also allowed

14
Stock Markets, Banks, and Economic Growth, American Economic Review (June 1998) pp.537-558.
61

agricultural farmers to sell some of their crops in a market and keep the proceeds from the sales.
This reform provided agricultural workers with a financial incentive to worker harder and so
should have increased total factor productivity. The reforms accelerated in the 1980s and 1990s
to allow a greater role for the market which has allowed total factor productivity and real GDP
per person to increase rapidly in China since the late 1970s.
[End Box]

5.4 Explain the Balanced Growth Path and Convergence and the Long-Run Equilibrium
The steady-state is the equilibrium for the economy; however, it is an equilibrium in which the
key economic quantities such as potential real GDP and potential real GDP per worker hour are
growing. Therefore, you can think of an economy as having an equilibrium time path for key
quantities such as potential real GDP and potential real GDP per worker hour. When the
economy is in the steady state it is on the balanced growth path. The balanced growth path is
the time path for the economy when it is in the steady state. Therefore, along the balanced
growth path the capital-labor ratio and potential real GDP per worker grow at the same rate and
the capital stock and potential real GDP grow at the same rate. Understanding the equilibrium
time path is critical for understanding the long-run behavior of potential real GDP and potential
real GDP per worker hour.

62

(MD: Balanced Growth Path The time path for the economy when it is in the steady state.
Therefore, along the balanced growth path the capital-labor ratio and potential real GDP per
worker grow at the same rate and the capital stock and potential real GDP grow at the same rate.)

When the economy is on the balanced growth path, the economy is also in the steady
state. Therefore, to determine the growth rate of potential real GDP per worker hour and
potential real GDP along the balanced growth path, we start by looking at the steady state.
Equations (5.6) and (5.7) tell us that the steady-state value capital-labor equals *

()

and
that the steady-state potential real GDP per worker hour is

()

()

. In the steady
state, the rates of investment, depreciation, and labor force growth along with capitals share of
income are all constant. However, if total factor productivity is growing then the capital-labor
ratio and potential real GDP per worker hour are growing. Table 5-4 on page xx shows they both
grow at the rate of (

in the steady state which means they grow at the rate of (

along the balanced growth path. Since (

is the growth rate along the balanced growth

path, (

is also the slope of the balanced growth path for potential real GDP per worker
hour and real GDP per person.
The capital stock is just the capital-labor ratio times the amount of worker hours in the
economy and potential real GDP is just potential real GDP per worker hour times the amount of
worker hours the economy employs. Therefore, the steady-state capital stock equals
*

()

and the steady-state potential real GDP equals

()

()

. As Table
63

5-4 on page xx shows the steady-state growth rates of the capital stock and potential real GDP
depends on the growth rates of the labor force and the total factor productivity. Table 5-4 on
page xx shows they both grow at the rate of *(

+ in the steady state which means they

grow at the rate of *(

+ along the balanced growth path. Since *(

+is the
growth rate along the balanced growth path, *(

+ is also the slope of the balanced

growth path for potential real GDP.
Figure 5-1 on page xx shows that the growth rates for the United Kingdom, the United
States and the entire world have been roughly constant since 1820 which suggests these countries
and the world are on or near the balanced growth path. Just as the steady state is the equilibrium
for the economy, the balanced growth path is the equilibrium for the economy so there is a built
in tendency for the economy to return to the balanced growth path after an event pushes the
economy off the balanced growth path. However, some countries such as Japan and China look
like they are off the balanced growth path for extended periods of time. This can occur when
either the balanced growth path changes or when the balanced growth path is constant, but some
event knocks the economy off the balanced growth path. When the economy is in the steady-
state, the economy is also on the balanced growth path. Therefore, if the steady-state is constant,
then the balanced growth path has not changed. However, when the steady-state changes the
balanced growth path will change.
The experiences of Germany and Japan after World War II provide a good example of
how an economy that is off its balanced growth path eventually converges back to the balanced
growth path. During the end of World War II, both Germany and Japan experienced a large
64

decrease in the capital-labor ratio as the United States and its allies bombed the factories,
bridges, and transportation networks in both countries. Figure 5-17 shows real GDP per person
over time for both Germany
Figure 5-17 Post World War II Convergence in Germany and Japan

SOURCE: Angus Maddison
Caption: Germany and Japan experience a large decrease in real GDP per person at the end of
World War II that you would expect due to the destruction of the capital stock. However, after
the War both countries grew much more rapidly than before the War. Germany grew rapidly
from the end of the War until about 1960. After 1960, Germany appears to grow at the same rate
65

as it was prior to the War. In fact, Germany appears to be on the same growth path after 1960 as
it was before World War II. Japan had a similar experience. Japan grew rapidly from the end of
the War until the mid 1970s, but appears to move to a higher balanced growth path compared to
the one it was on before World War II.
End Caption
and Japan. Both countries experience a large decrease in real GDP per person at the end of
World War II that you would expect due to the destruction of the capital stock. However, after
the War both countries grew much more rapidly than before the War. Germany grew rapidly
from the end of the War until about 1960. After 1960, Germany appears to grow at the same rate
as it was prior to the War. In fact, Germany appears to be on the same growth path after 1960 as
it was before World War II. Japan had a similar experience. Japan grew rapidly from the end of
the War until the mid 1970s, but appears to move to a higher balanced growth path compared to
the one it was on before World War II. Because Japan moved to a higher balanced growth path,
the steady-state capital-labor ratio and potential real GDP per worker hour must have increased.
Why do countries return to the balanced growth path? We can use the Solow growth and
the experiences of Germany and Japan to explain why. Using Germany as our example, Figure
5-18 shows the effect of the
Figure 5-18 The Solow Growth Model and Post-World War II Convergence in Germany


66












Caption: Germany starts off in the steady state at point A prior to World War II. Since Germany
is in the steady state, Germany is also on the balanced growth path so the capital-labor ratio and
potential real GDP per worker hour both grow at rate (

. Towards the end of the War, the

Soviet Union, United Kingdom, and United States bombed German factories, bridges and
transportation networks which destroyed large portions of the German capital stock. As a result,
the capital-labor ratio decreased from

to

and real GDP per worker hour decreased from

to

. The decrease in labor productivity caused the decrease in potential real GDP per
person at the end of World War II that we see in Figure 5-17. Total factor productivity
Capital-Labor Ratio

Production Function
Investment
Function
Break-Even
Investment Line
A

( )

1. Prior to World War
II Germany is in the
steady state so it is on
the balanced growth
path.
2. The United States and its
allies bomb Germany which
decreases the capital-labor ratio
and causes potential real GDP
per worker hour to decrease.
3. As a result, investment is greater than the
break-even level of investment so the capital-
labor ratio and real GDP per worker hour
converge to the steady-state values.
67

continued to grow in Germany which caused potential real GDP per worker hour and real GDP
per person to grow. However, now that the capital-labor ratio had fallen to

, the German
economy grew for an additional reason: it accumulated capital more quickly than along the
balanced growth path. At

, the level of investment,

, was greater than the break-even

level of investment, ( )

so the capital-labor ratio increased towards the steady state

value of

. From 1945 to 1960, the capital-labor ratio in Germany was increasing for two
reasons. First, total factor productivity growth was positive so the growth rate of the capital-
labor ratio along the balanced growth path was positive. Second, Germany was converging from
the capital-labor ratio of

towards the steady-state capital-labor ratio of

. Since the
growth rate of the capital-labor ratio determines the growth rate of potential real GDP per worker
hour, the growth rate of real GDP per worker hour also had two sources: balanced growth due to
total factor productivity growth and growth due to the convergence of

to

.
End Caption
destruction of the capital stock on potential real GDP per worker hour. Germany starts off in the
steady state at point A prior to World War II. Since Germany is in the steady state, Germany is
also on the balanced growth path so the capital-labor ratio and potential real GDP per worker
hour both grow at rate (

. Towards the end of the War, the Soviet Union, United Kingdom,
and United States bombed German factories, bridges and transportation networks which
destroyed large portions of the German capital stock. As a result, the capital-labor ratio
decreased from

to

and real GDP per worker hour decreased from

to

. The
decrease in labor productivity caused the decrease in potential real GDP per person at the end of
World War II that we see in Figure 5-17. Total factor productivity continued to grow in
68

Germany which caused potential real GDP per worker hour and real GDP per person to grow.
However, now that the capital-labor ratio had fallen to

, the German economy grew for an

additional reason: it accumulated capital more quickly than along the balanced growth path. At

, the level of investment,

, was greater than the break-even level of investment,

( )

so the capital-labor ratio increased towards the steady state value of

. From
1945 to 1960, the capital-labor ratio in Germany was increasing for two reasons. First, total
factor productivity growth was positive so the growth rate of the capital-labor ratio along the
balanced growth path was positive. Second, Germany was converging from the capital-labor
ratio of

towards the steady-state capital-labor ratio of

. Since the growth rate of the

capital-labor ratio determines the growth rate of potential real GDP per worker hour, the growth
rate of real GDP per worker hour also had two sources: balanced growth due to total factor
productivity growth and growth due to the convergence of

to

. In general, we can think

of the growth rate of potential real GDP per worker hour as:

( ) ( )
As long as the capital-labor ratio is less than

growth from convergence is positive so the

German economy is growing more rapidly than it does along the balanced growth path.
Therefore, potential real GDP per worker hour converged towards

so real GDP per person

converged towards the balanced growth path. However, if an economy starts off with a capital-
labor ratio that is greater than

then the capital-labor ratio will decrease over time so growth

from convergence will be negative. As a result, the economy will grow more slowly than along
the balanced growth path so potential real GDP per worker will converge to the balanced growth
path.
69

The experience of Germany is consistent with Germany returning to the pre-World War
II steady state and so the pre-World War II balanced growth path. However, Japan looks like it
converged toward a higher balanced growth path. This is consistent with an increase in the
steady-state capital-labor ratio and potential real GDP per worker hour in Japan. Question xx on
page xxx asks you to explain how this could occur.
[Begin Box]
Making the Connection: When will Chinas Standard of Living Exceed the U.S. Standard
of Living
In 2008, the real GDP per person was 5.5 times higher than that of Chinas. However, the
growth rate of real GDP per person has averaged 7.0 percent per year in China since the start of
economic reforms in 1978 while the growth rate of real GDP per person in the United States has
averaged just 1.9 percent per year over the same time period. Since China the standard of living
in China is growing more rapidly than in the United States, eventually Chinas standard of living
will catch up to and exceed the U.S. standard of living. At those rates of growth, the Chinese
standard of living will exceed the U.S. standard of living in the year 2043. However, what we
have learned about economic growth gives us very good reasons to think that, just like Germany
and Japan, China will not be able to sustain these rapid growth rates for the indefinite future.
The growth rate of real GDP per person along the balanced growth path is determined by
the growth rate of total factor productivity. For China to maintain its high rates of growth in real
GDP per person, China would have to maintain high rates of growth for total factor productivity,
but that is unlikely. First, the United States investments more in activities such as research and
70

development which result in new technologies and increase total factor productivity. Second,
much of Chinas growth is likely due to the transition from a communist to a market economy so
Chinas growth rate is likely to decrease as the transition is completed. It is probably best to
think of the transition to a market economy as moving Chinas balanced growth path higher.
The high rates of growth in real GDP per person are due to convergence to the higher growth
path. As China approaches the new higher balanced growth path, we would expect Chinas
growth rate to decrease to a more sustainable rate.

SOURCE: Penn World Tables
[End Box]
Figure 5-19 shows what the time paths of real GDP per person would look like for an
Figure 5-19 Potential Time Paths for Real GDP per Person







Balanced growth path
Time path for a country initially
below the balanced growth path
Time path for a country initially
above the balanced growth path
Time
Natural logarithm of real
GDP per person
71

Caption: If an economy is on the balanced growth path then it remains on the path until an event
moves the economy off the path. When the economy is on the balanced growth path, the growth
rate of potential real GDP per person is determined by the growth rate of total factor
productivity. If an economy starts off below the balanced growth path then growth from
convergence is positive so the economy grows faster than it would along the balanced growth
path and eventually converges to the balanced growth path. If an economy starts off above the
balanced growth path then growth from convergence is negative so the economy grows slower
than it would along the balanced growth path and eventually converges to the balanced growth
path.
End Caption
economy on the balanced growth path initially, an economy initially below the balanced growth
path, and for an economy initially above the balanced growth path. If an economy is on the
balanced growth path then it remains on the path until an event moves the economy off the path.
When the economy is on the balanced growth path, the growth rate of potential real GDP per
person is determined by the growth rate of total factor productivity. If an economy starts off
below the balanced growth path then growth from convergence is positive so the economy grows
faster than it would along the balanced growth path and eventually converges to the balanced
growth path. If an economy starts off above the balanced growth path then growth from
convergence is negative so the economy grows slower than it would along the balanced growth
path and eventually converges to the balanced growth path.

72

Answering the Big Question
What we learned in this chapter helps answer two Big Questions from Chapter 1:
Big Question 1: Why has the standard of living increased over the last two hundred
years?
Big Question 2: Why have some countries failed to achieve sustained economic growth?
The standard of living has increased because increases in TFP have driven labor productivity
higher. Higher labor productivity then leads to a higher standard of living. A well-functioning
financial system and a government that protects property rights increase the likelihood of a
country achieving sustained economic growth.

Conclusion
In this chapter, we showed that the growth rate of total factor productivity is the key
factor in explaining the long-run equilibrium growth rates of labor productivity and the standard
of living. Economists do not have a definitive explanation for why total factor productivity
differs across countries. However, we do know some of the factors that are important in
explaining differences in total factor productivity and labor productivity. Especially in advanced
nations the amount of resources devoted to R&D and the discovery of new knowledge should
influence the capital goods are important. In addition, the quality of government institutions and
the quality of financial markets play an important role in determining total factor productivity.
73

Economists do know that the growth rate of total factor productivity determines the
growth rate of labor productivity and the standard of living in equilibrium. Economists also
know that an economy tends to converge towards its equilibrium growth path. Convergences
helps explain why Germany and Japan grew so rapidly in the first decade or two after World
War II, but have grown more slowly since then.
In Chapter 6, we will cover money to understand how the inflation rate is determined in
the long run. Before moving on to that chapter, read An Inside Look on the next page to learn
how..
Summary
5.1 Discuss the Connection between Labor Productivity and the Standard of Living
Real GDP per person tells us the amount of goods and services that the average person in
an economy can consume. If an individual is rational, then he will purchase goods and services
that make himself better off. So, real GDP per person is a useful measure of the standard of
living. The standard of living is labor productivity multiplied by labor input measured as
average hours worked per person. The population is finite and there are just 24 hours in a day,
so there is a limit to how much increasing labor inputs can increase the standard of living.
However, labor productivity can increase indefinitely and as long as labor productivity increases
the standard of living can increase. Real GDP per person is not a perfect measure of the standard
of living because it ignores the distribution of income, the value of leisure time, whether people
are happy or not, and life expectancy. However, the incomes of the poor, leisure time, self-
74

reported happiness and life expectancy all tend to increase as real GDP per person increases.
Although imperfect, real GDP per person remains a very good measure of the standard of living.

5.2 Use the Solow Growth Model to Explain the Effect of Capital Accumulation onLabor
Productivity
Labor productivity depends on the capital-labor ratio and the level of TFP. The capital-
labor ratio depends on the level of investment and the break-even level of investment, is the level
of investment necessary to keep the capital-labor ratio constant. The steady state occurs when
investment equals break-even investment and the capital-labor ratio is constant. An increase in
the investment rate leads to a higher capital-labor ratio and a higher level of labor productivity.
Because financial markets work to ensure that savings flow into investment, anything that
increases saving will lead to a higher investment rate, a higher capital-labor ratio, and a higher
level of labor productivity, all else equal. Anything that decreases saving, such as a government
budget deficit, will cause the reverse to happen, all else equal. The break-even level of
investment is determined by the growth rate of the labor force and the depreciation rate. A
decrease in either the depreciation rate or the labor force growth rate decreases the break-even
level of investment. As a consequence, the capital-labor ratio and level of labor productivity are
higher. Increases in the depreciation rate or labor force growth rate cause the reverse to happen.

5.3 Explain how Total Factor Productivity Affects Labor Productivity
75

TFP measures the overall efficiency of the economy in transforming inputs into goods and
services. TFP is not subject to diminishing marginal returns, so increases in TFP can explain
sustained increases in labor productivity. Since labor productivity is the key determinant of the
standard of living, TFP growth also explains sustained increases in the standard of living. TFP
also explains the large differences in labor productivity and the standard of living across
countries as well. To understand labor productivity and the standard of living fully, we must
understand why TFP changes over time and why TFP is higher in some countries than others.
Unfortunately, economists do not have a complete explanation for why TFP differs over time
and across countries. However, economists have identified these important factors:
(1) Investment in R&D leads to new ideas and new products that make workers more
productive.
(2) Education and learning by doing increase the skill level of the labor force.
(3) Good government and social institutions channel resources toward wealth creating activities
and away from wealth redistribution activities.
(4) Geography and climate determine a nations natural resources and the rate of infectious
disease among the population.
(5) A well-functioning financial system ensures that savings flow to the individuals with the
most productive investment projects and may lead to higher levels of physical and human
capital.
5.4 Explain the Balanced Growth Path and Convergence and the Long-Run Equilibrium
76

Potential real GDP and potential real GDP per worker hour grow during equilibrium. The
equilibrium growth rate is determined by the growth rate of total factor productivity. When an
economy initially has a capital-labor ratio that is below the steady-state value, the capital-labor
ratio grows quickly so potential real GDP per worker hour converges to the balanced growth
path. When an economy initially has a capital-labor ratio that is above the steady-state value, the
capital-labor ratio grows slowly so potential real GDP per worker hour converges to the balanced
growth path.
AUTHORS WILL ADD PROBLEMS IN NEXT DRAFT

Appendix: Describe How Capital Accumulation Causes Endogenous Growth
Capital accumulation and total factor productivity growth are the two determinants of
labor productivity and the standard of living. Due to diminishing marginal returns, growth from
capital accumulation eventually dies out so total factor productivity growth is the ultimate
determinant of the growth rate of labor productivity and the standard of living. According to the
Solow growth model, a low growth rate of total factor productivity causes a low growth rate of
the standard of living. The answer is very clear and precise, but where does total factor
productivity growth come from? The Solow model just assumes that total factor productivity
growth occurs, so the model just assumes different growth rates of labor productivity and the
standard of living. The model doesnt explain why the growth rate of the standard of living is
low in some countries.
77

Endogenous growth theory tries to solve this problem inherent in the Solow growth
model. Endogenous growth theory is a theory of economic growth that tries to explain the
growth rate of total factor productivity. There are many different endogenous growth models,
and we do not intend to explain them all. Instead, we introduce one of the simplest versions of
the theory that focuses on the importance of capital accumulation. To highlight how capital
accumulation can lead to productivity growth, we assume that the quantity of labor is fixed at 1
and that total factor productivity is also fixed. Given these two assumptions, the only way that
labor productivity and the standard of living can increase is if the capital stock increases. A
common aggregate production function in endogenous growth models is:
(A.1) .
(MD: Endogenous Growth Theory A theory of economic growth that tries to explain the
growth rate of total factor productivity.)
Notice that there are no diminishing marginal returns to capital in this aggregate production
function. In fact, the marginal product of capital always equals A so the marginal product of
capital is constant. Because the marginal product of capital is constant, capital accumulation can
drive productivity growth. In addition, the growth rate of potential real GDP equals the growth
rate of the capital stock.
Assuming a constant marginal product of capital makes sense if we use a broader
interpretation of the K term in the aggregate production function.
15
For example, K may

15
Paul Romer, Crazy Explanations for the Productivity Slowdown, In NBER Macroeconomics Annual 1987, vol 2,
ed. Stanley Fischer. Cambridge, Mass.: MIT Press, 1987. Sergio Rebelo, Long-Run Policy Analysis and Long-Run
Growth, Journal of Political Economy (June 1991) pp. 500-521.
78

include not just physical capital, but also human capital. Recall that human capital is the
knowledge and skills that the workers in the economy possess. If an economy accumulates
physical and human capital at the same rate, then the ratio of physical to human capital remains
constant and the marginal product of capital may not decline. Why would human capital
increase with physical capital? As physical capital increases, a country becomes richer and the
country may invest more in education and devote more resources to on-the-job training.
Increased education and on-the-job training should both lead to more human capital. In addition,
as an economy accumulates more capital goods of a given type, learning by doing occurs, so the
existing workers become more proficient using the capital goods. The more highly skilled
workers can keep the marginal product of capital from declining. Finally, we may consider the
stock of knowledge as one type of capital good. As the stock of ideas increases, the economy
can produce new and better types of capital goods and, as a consequence, the marginal product of
capital does not decline.
The aggregate production function with a broader definition of capital has important
consequences for our theory of economic growth. To see these consequences, think in terms of
the bath tub analogy that we introduced on page xx (add in page proofs). The investment rate, s,
is still a constant fraction of output. Given our aggregate production function, water flowing into
the bath tub is now:
.
We have assumed a constant labor force, so the growth rate of the labor force, n, equals zero and
water flowing out of the bath tub is now:
79

.
So, the change in the level of water in the bath tub, , equals:
.
We can divide each side of the equation by the capital stock to find an expression for the growth
rate of the capital stock:

.
Given the new production function in equation (5.18), the growth rate of potential real GDP is
(A.2)

.
Because we have assumed a constant labor force, equation (A.2) also tells us the long-run growth
rate of labor productivity. In the Solow growth model, the growth rate of labor productivity
depended on an assumed rate of TFP growth. However, equation (A.2) tells us that the growth
rate of productivity depends on the investment rate, so the investment rate emerges as an
important determinant of the growth rate of labor productivity and the standard of living. In
addition, government policies that either increase or decrease the investment rate become
important determinants of the standard of living. For example, the U.S. government has special
tax credits designed to promote investment in capital goods and research and development. This
endogenous growth model provides an answer to why countries experience high or low growth
rates of the standard of living: countries with high investment rates experience high growth rates
and countries with low investment rates experience low growth rates.
80

The Evidence on Endogenous Growth Theory
The endogenous growth model we just described predicts the relationship between the
investment rate and the growth rate of labor productivity and the standard of living. Equation
(A.2) says that as the investment rate increases, the growth rate of labor productivity also
increases. All else equal, the higher investment rate should lead to a higher growth rate of real
GDP per person. Charles Jones of Stanford University examined this prediction using data from
advanced economies and found that growth rates of real GDP per person are roughly constant
over long periods of time, but that the investment rates increased significantly during the post-
World War II era.
16
If the endogenous growth model is correct, then Jones should have found
that the increase in the investment rates were associated with higher growth rates of real GDP per
person. Instead, he found that growth rates of real GDP per person have been constant over time.
He interprets this finding as evidence against the simple endogenous growth models. The
evidence that Charles Jones presents suggests that the simple model of endogenous growth does
not does not explain the long-run performance of advanced economies. However, research on
endogenous growth has moved beyond the simple models described here to more advanced
models that fit the data better.

Mathematical Appendix
Solving for the Steady State Capital-Labor Ratio and Real GDP per Worker Hour
Equation (5.5) describes how the capital-labor ratio changes over time:

16
Time Series Tests of Endogenous Growth Models, Quarterly Journal of Economics (May 1995), pp.495-525.
81

(

) ( ).
In the steady-state, the capital labor ratio is constant. Therefore, to find the steady-state capital-
labor ratio first set so:
(

) ( ).
Next divide by k on each side of the equation:
(

) ( ).
Isolating the capital-labor on the right-hand side, we have

Raising each side of the equation to the

power yields:

.
We can transform this into:

.
To find the steady-state real GDP per worker hour plug this expression into the production
intensive form production function

to get:

()

.
Now just rearrange terms so that there is just one term representing A, total factor productivity:

()

()

.
Calculating the Steady-State Growth Rates
Capital-Labor Ratio
82

The steady-state capital-labor ratio is

.
In the steady state, capitals share of income, the investment rate, the depreciation rate and the
growth rate of the labor force are all constant. However, total factor productivity may increase.
Therefore, it will be helpful to rewrite the equation for the steady-state capital-labor ratio as:

()

where we include the t subscript to emphasize that the capital-labor ratio and total factor
productivity change over time. Following what we learned in the Chapter 4 Appendix we can
take the natural logarithm of each side of the above equation to get:

) *

+ .
The derivative of the natural logarithm of the variable X
t
with respect to time is:

.
Apply this rule and the rules for derivatives that we learned in Chapter 4, we find that the growth
rate for the steady-state capital-labor ratio is:

.
Real GDP per Worker Hour
The steady-state real GDP per worker hour is
83

()

()

.
Just as it was helpful to use time subscripts for the expression for the steady-state capital-labor
ratio, it is also helpful here to emphasize that real GDP per worker hour and total factor
productivity may change over time:

()

Following what we learned in the Chapter 4 Appendix we can take the natural logarithm of each
side of the above equation to get:

) *

+ .
Apply the rule for taking the derivative of a variable with respect to time and the rules for
derivatives that we learned in Chapter 4, we find that the growth rate for the steady-state capital-
labor ratio is:

.
Real GDP
Real GDP per worker hour is defined as

. We can rewrite this definition by multiplying by

labor on each side of the equation to obtain:
.
The labor force and real GDP per worker hour grow over time so write the above equation as:
84

Apply the rule for taking the derivative of a variable with respect to time and the rules for
derivatives that we learned in Chapter 4, we find that the growth rate for the steady-state capital-
labor ratio is:

.
The labor force grows at a constant rate of n so the above equation becomes:

.
When the economy is in the steady-state, the growth rate of real GDP per worker hour is

so
the growth rate for real GDP in the steady state is:

.
Now we can substitute in the expression for the steady-state growth rate of real GDP per worker
hour to obtain: