Macroeconomic policy—monetary and fiscal policy, as well as trade and industrial policies, may or may not create a growth oriented environment; this includes the openness of the economy to trade and competition that helps it utilize its resources to maximum advantage. Political stability and a legal structure that securely defines and protects property rights are essential to the development of a growth-oriented environment. Social and cultural attitudes can also affect the ability of a given economy to exploit the available resource base.
The analysis of the sources of economic growth starts with the production function:
Y = A * F (K, N)
The level of output (really the potential or the natural rate of output, since it is assumed that all resources are in fact utilized), Y, is a function of capital, K, and labor N, inputs. Furthermore, the whole production frontier increases or shifts out as the level of technology, A, increases.
Labor productivity growth, the growth of real output per unit of labor input (e.g., hours worked) is the primary source of growth in real wages. To see this, look at the labor share definition of a N in rate of growth terms and rearrange:
There are empirical studies that decompose the growth of output into its various sources. Given the capital and labor shares, we can attribute the observed growth of real product into portions due to capital and labor inputs. Total factor productivity is the residual or that portion of output growth not explained by growth of the inputs.
Sources of Economic Growth
- How to Increase Productivity Growth : An interesting conjecture would be to calculate what labor productivity growth would have been in the 1980s if the capital stock had grown as rapidly as it had in earlier decades. Suppose that DK K = 4.4 percent; then the calculation of labor productivity growth would be: 0.6 + 0.26 (4.4. – 1.8) = 1.3
The model will have the following components:
MODEL OF LONG-RUN EQUILIBRIUM
Money is the stock of assets used to conduct transactions. In addition, holdings of money represent a store of value because they can always be exchanged for goods. Finally, the money unit of account (e.g., dollar, franc, or yen) provides a common reference unit for quoting prices (called a numeraire). Although there is general agreement about this conceptual definition, it is often difficult to implement it specifically.
- The equilibrium level of output which is determined by the production function and the labor market. The supply and demand for labor determine the equilibrium real wage and the level of employment.
- A distribution model that shows how the equilibrium output is divided between consumption goods and investment goods. This part of the model explains the determination of the real interest rate and also the level of investment.
- A monetary sector that relates the money stock to the price level.
- An international or open economy sector that relates the equilibrium to exchange rates.
- Output Equilibrium: The production function—Y = A×F (K, N)—can be used to derive the long-run equilibrium level of output. To begin, we will take the level of technology (A) and the capital stock (K) to be given. The equilibrium level of output then depends on the size of the labor input into production. The labor input is determined by labor market equilibrium.
- Quantity theory of money: The long-run equilibrium view of the money sector is given by the Quantity theory of money: MV = PY
- Interest rate parity Domestic interest rate is equal to foreign interest rate less the expected rate of exchange rate depreciation .