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EC102 Macro week 1 – Introduction (slides 1-5) & Economic Growth (slides 6-25)
Introduction
Macroeconomics is largely about the following 5 topics:
i) Long-run growth
ii) Booms and recessions (i.e. economic fluctuations – tendency of economic activity to
expand or contract over short periods of time)
iii) Inflation and deflation
iv) Unemployment
v) Financial, currency, and sovereign debt crises
Macroeconomics is a topic that delivers tools to understand every-day events (e.g. Brexit).
Economic Growth
Economic growth is the mechanism through which societies deliver higher living standards.
In particular, the stress is on the long-run nature of economic growth – generation after generation,
producing higher and higher living standards.
Living standards is made up of many things, some of which are psychological and spiritual and so
have nothing to do with the economy.
So, economics is more about material living standards – largely things we can measure quantitatively
e.g. goods, services, health, education etc.
Economics is therefore about whatever kind of contribution we can obtain from material things like
goods and services over the long-run.
Let’s address three preliminary questions about growth:
• How do we measure economic growth?
o In practice, what is the best way of assessing how well our societies are doing with
growth
• Is indefinite growth feasible?
o Also, importantly, many people are sceptical that the idea of keeping growth going
forever is feasible
o There are arguments given for why this is not feasible, and we will discuss this later
• Is indefinite growth desirable?
o Before we embark on a study of how we can ensure growth keeps going, we also
want to make sure we are convinced that growth is a desirable thing
Question 1: how do we measure economic growth?
Addressing the first question, we defined growth as an improvement in living standards, so we need
a measure of material living standards.
Measuring growth 1: GDP per capita
A very standard, traditional way of measuring living standards is gross domestic product per capita.
This is the value of all goods and services produced by the economy in a year (quarter if looking at
economic fluctuations), divided by population.
,So, GDP is the total value of the goods and services produced over a period of time, usually a year.
We then divide this by the population to get a ‘per person’ measure. This is because we aren’t just
interested in the size of the cake created by the economy, but the size of each slice given to people
when considering living standards. It differs when divided by many or by a small number of people.
Hence, GDP is a sensible way of thinking about living standards because it tells us how much stuff
there is to share among people. Then, if this were divided equally among people in society, it tells us
what everyone gets from this pile.
It captures the quantitative material living standards of the average person, which is why this is a
traditionally popular measure of growth.
However, this measure is not immune to criticism. For example, we divide equally in the population,
but this may not be the case in reality. This also applies to changes in GDP per capita, which could
just go to a small group in society.
It would then be harder to interpret changes in GDP per capita as changes in the living standards of a
typical person. It would just tell us that the economy has produced more goods and services, not
whether the typical person has received more goods and services.
Measuring growth 2: median income
To deal with this, some economists have advocated giving more weight to alternative measures. One
of these is median income, and more particularly, median household income.
Firstly, we must explain what a household income distribution is. This is a description of how many
households are at each level of income. These can be adjusted by family size, to find equivalent
scales e.g. a family of 8 people having £X being equivalent to a family of 4 people having £Y.
Once we’ve done this, we can identify the household where 50% of households have lower income,
and 50% higher, and so this level of household income is in the middle (the 50th percentile) and is
known as the median household income.
Median income can be argued to be a better measure than GDP.
Measuring growth 3: multi-dimensional approaches
The two measures discussed so far are common in the sense that they try to summarise living
standards with a unique number. That approach has been criticised because there are actually so
many different dimensions and aspects that affect living standards and so trying to summarise it
with a single number may be inadequate.
The Stiglitz commission have pushed this argument the most. They propose to adopt a dashboard
approach, which means we keep an eye on many different aspects such as: health, education,
personal activities, environmental conditions, social conditions, political voice, and insecurity.
However, this is unlikely to be successful because there is a tendency in policy, politics and the
media to simplify arguments and to focus on a very narrow measure.
Another option is the UN Human Development Index. This is an attempt to compromise the single-
measure and the multi-dimensional dashboard approach. It is still a single measure, but it combines
GDP, education and life expectancy in a single figure. Again, this can be criticised: why these 3 things
but not others?
* Ignore Utility-based index in the slides *
,Measuring growth 4: keeping track of resource use
One thing we have seen in the dashboard approach was measures of environmental quality. A
related argument has to do with the depletion of natural resources.
One funny aspect of GDP is that some activities that are using up resources actually count as
production (e.g. in mining, the value of extraction goes into GDP but at the same time we are
reducing the number of resources remaining).
Another proposal is to use GDP but keep track of natural resources being used up: GDP minus
depletion
So, we have seen a number of alternatives to GDP, all of which have their own strengths and
weaknesses, but everybody is still largely using GDP.
So, the question is: when is it ok to focus on GDP? It seems to largely correlate with many of the
other measures of living standards, but only strongly over long periods of time and across countries
with very different living standards.
Question 2: is growth sustainable?
Dealing with the second question, there are some people that argue that it is fundamentally
impossible that growth can happen indefinitely. There are two separate arguments.
Problem 1: running out of natural resources
When you produce goods and services, you are using up natural resources (e.g. oil, gas etc.) and
these are finite. Therefore, we cannot grow indefinitely.
How strong is this argument? Well, this is weaker than the second argument (to be introduced next)
because we have ways of dealing with the finite nature of natural resources through scientific and
technological progress.
Some of these solutions are:
• Substitution – historically, whenever a resource started becoming scarcer, we have been
able to find substitutes
o Right now, we are in the middle of a large substitution away from fossil fuels to
renewable energy sources (e.g. solar and wind)
• Efficiency improvements – the idea that we become smarter at doing more with the same
quantities of natural resources
o If you need a metal in some production (e.g. cars), we become good at using less
and less of that metal
o For example, at the beginning of the 1900s, we used enormous amounts of iron in
cars, and now we use very light aluminium bodies
o Also gains in efficiency in using less gas/petrol in cars
• Recycling – even if the above two fail, in principle recycling will never fail
o For example, if some rare metal is needed for iPhones, we can use discarded phones
to reuse in new production
o Conceptually, recycling is a solution to any scarcity problem (energy is always
transformed into something else, so we just need to find ways to recapture this)
Ok, in principle we could use these three, but is it going to happen?
, Well, the other reason that economists are relaxed with this issue is that there are spontaneous
market mechanisms that induce these solutions.
What we mean is that when something becomes scarce, the price of it goes up. There is nothing that
triggers the 3 solutions as promptly as changes in price. This higher price means that anybody that
can provide an alternative can charge even more, so there are large profits that can be gained from
improving on these alternative resources.
We see this in reality, where an increase in oil price results in a flurry of R&D focused on alternative
forms of energy, and they back off once the price falls.
Similarly, a price increase induces manufacturers to invest in efficiency gains to capitalise on profits.
Also, there is money to be made from recycling as there is an incentive to get that expensive
resource to then resell.
So, there are 2 parts to the solution argument: there are technical responses, and there is the
market mechanism.
Problem 2: environmental degradation and climate change
This second problem is much more serious. This has to do with the fact that the growth process
which involves a lot of manufacturing, transportation etc. causes leakages in the environment that
are harmful (e.g. emissions, degradation of soil and water).
Note that just because GDP goes up, it doesn’t mean we are better off.
Also, if this keeps on happening, it can have catastrophic results, with one example being climate
change. This has the potential to cause so much devastation to many economies in the world, which
can result in a collapse in living standards.
Looking again at the technical and market solutions and whether they apply here, we see that
substitution, efficiency and recycling are still key.
For a substitution example, switching from eating cows to eating vegetables (because cows produce
methane which is a greenhouse gas), can help.
For an efficiency example, if we all insulate our houses better, there is less leakage of heat and so
less heating is needed.
For a recycling example, recycling more means less waste goes to the landfills and incinerators which
produce greenhouse gases.
However, in the case of markets, it fails here due to the presence of externalities.
An externality arises when agents engage in activities that have an impact on others, but for which
there is no market.
A consumption good does not result in an externality as there is a price that results in a market.
However, the price adjustment mechanism is not there for externalities. For example, the cost of
pollution from cars does not change whether the air is good or bad.
We would like a mechanism where you have to pay more when the air is bad (i.e. regulation) which
is only possible with government intervention and public policy.
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