MACROECONOMICS III

TOPIC 1: INTRODUCTION TO ECOMOMIC GROWTH AND DEVELOPMENT

 What is economic growth? The sustained increase in per capita income, whose process was different
since industrial revolution.
 What is economic development? It has to do with improving the income, well-being, and economic
capacity of people, therefore, the aim is to achieve a huge level of economic development of each
country to get a happier society.
1. The facts to explain
There are substantial differences in the economic circumstances in which live the 8,000 million people who
inhabit the earth. India is now the most populated country, followed up by China which was the most one a
year ago. These differences are showed by different indicators, which have different results depending on
high-low income countries. There are a lot of indicators such as life expectancy at birth (which is 62.7 years
in low-income countries, 80.8 in high-income countries), infant mortality, electricity, number of cars per
household, level of education... It is worth asking where the origin or cause of these differences lies (a
question that Adam Smith already asked himself in 1776).
In any case, even this process took a certain level of importance after industrial revolution, between
Smith's time and the current one, in all countries, the variables that reflect the level of wealth have
changed substantially. In all they have improved, and even in those with lower incomes today the standard
of living is higher than what a member of high society in a rich economy could have in 1820. This has
happened in all countries except in Argentina, which was one of the 5 richest countries 200 years ago, and
today it is completely different. In 1960 the world GDP pc was 459,1 $ and in 2021 12,262.9 $.
Another variable that reflects the level of wealth is the difference that we work less and less, so we have
more and more time for leisure. Keynes already predicted something like this, and although this is a
hypothesis, maybe with robotization, we will dedicate ourselves to leisure even more.
1.2. The key question
In any case, the key question is what the source of that growth is (of that change in the indicators). Will rich
countries get richer and richer? Will the poor converge? Are the problems linked to the environment a limit
to the problem, or will technological progress solve it?

2. Differences in growth rates

2.1. First explanation
The first explanation of the differences in levels of wellbeing comes from the measurement of growth. This
is done basically from GDP: income or national product (set of goods and services produced during a given
period). Nevertheless, between countries is better GDP pc, that is the income or production per capita
(GDP/population). This explanation has several critics saying that GDP is not an adequate indicator of the
total amount of goods and services produced in the economy, and that income distribution is not
considered. An alternative method is using Human Development Index (HDI) prepared by the United
Nations Development Program (UNDP).
In any case, the most used indicator for measuring the economic level of a nation is GDPpc. So, in order to
establish comparisons between countries we have to overcome the obstacle of the differences in
currencies and price level. This is done in a process of 2 phases:
 - The first is solved by using the dollar as the reference monetary unit.
- The second is calculating GDP pc in the same unit of measurement.
The effect of using PPP on comparisons of market leads to problems of using market exchange rates:
a. Its variations do not have to reflect a variation in the quantity of goods and services produced,
because that differences between levels of wellbeing are bigger in countries with less GDPpc using
market exchange rates.
b. The price of goods traded in international markets (relative to those that are not traded) tends to
be higher in poor countries than in rich ones.
c. The price of traded goods tends to be the same when they are converted to a common currency at
the market exchange rate (law of one price).
d. Consequence comparisons of GDP at market exchange rates underestimate the relative income of
developing countries.
2.2. Second explanation
The second explanation of the difference between countries is given by the difference in the rate of
economic growth. Growth rate measurement is the growth rate in two years, given by this equation:
X t+1 −X t
g=
Xt

Growth rates are a graphic representation of a variable that growths at a constant rate (exponential
growth): linear scale and logarithmic scale (ratio scale). We can change the previous formula to find the
average growth rate over several years: X t +n =X t∗(1+ g)n
1
X t +n n
Then, if X t and X t +n is known, we can reorder them again having: g=( ) −1
Xt

To graph the growth of variables over time, it is useful to use ratio scales. With a ratio scale, equal spaces
on the vertical axis correspond to proportional differences in the variable represented. In the linear scale
equal spaces correspond to absolute differences in the variable. If there is a constant growth rate, the
graph on a ratio scale will give rise to a straight line, because the proportion in which the variable changes
is the same every year. The graph shows constant growth data at 3% for 200 years.
2.3. Rule of 72
A useful mathematical approximation for dealing with growth rates is the rule of 72. This rule is a good
72
approximation to know how long it can take to double the level of growth by doubling time ≈
g
2.4. The facts
There are huge differences in per capita income between economies. The poorest countries have per
capita incomes that are less than 5% of the incomes of the richest countries. According to 2020 data from
(World Bank):

- Richest Country: Luxembourg $117,846.10

- Poorest country: Burundi $771.16
In Burundi they live with 0.65% of the per capita income of Luxembourg. In Spain ($37,756) we live with
32% of the per capita income of Luxembourg. USA ($63,206) lives on 53.6% of Luxembourg's per capita
income. It is important that:
1. Economic growth rates vary greatly between countries.
2. Rule of thumb: a country growing at g% per year will double its income every 72/g year.
3. Growth rates are not constant over time and tend to be higher when you are emerging countries
and tend to be lower when you are emerged countries. So, countries can change from being poor
to be rich.
4. The relative position of a country in the world distribution of per capita income can change.
Countries can change from being poor to being rich and vice versa.
Another important issue is that here we are assuming that the differences between countries are given by
their average income levels. In this sense, we could understand that an inhabitant of a country has an
income level equal to the average of his country. And that the difference in standard of living between the
inhabitant of one country and another is explained by the difference in income between their countries.
However, the difference in income within the country also matters. Thus, inequality in the distribution of
world income is the result of inequality between countries and inequality within each country.
The question is which of the two is more important. The following graph shows the importance of each
inequality from 1820 to 1992. As can be seen, since 1820 world inequality has grown (although it grew
above all until WWII). As of 1980, world inequality decreases, and the trend is that in data after 1992. The
main source of inequality is inequality between countries, which would explain 60% of global inequality. In
1820, 87% of inequality was within the country, and since then it has remained more or less constant, and
the one that has grown has been the inequality between countries.
2.5. The framework of analysis
The differences in per capita income of countries are linked to the key variable that defines economic
activity and that is production. Specifically, they depend on the amount of output generated. That amount
of output generated depends on the accumulation of inputs used to generate the output. And the
productivity with which those outputs are used.
The fundamental element from which modern economic growth theories are built is therefore the
production function: Yt = F (Kt,Lt; Nt)  Y: product; K: capital stock; L: number of workers employed; N:
natural resources.
The data allows us to test the theories, that is, it is necessary to contrast the theories with data analysis
(econometrics).
2.6. What is development?
Economic development is the main objective of most countries in the world: the objective would be to
improve the income, well-being and economic capacity of the people. But how is it measured? Is
development and growth the same?
When we think of a “developed” society:
a. Its population is well fed and well clothed.
b. Have access to a whole variety of products.
c. Can afford to enjoy some leisure and entertainment.
d. Live in a healthy environment.
e. There is no violent discrimination.
f. People receive proper medical assistance.
g. People don't have to sleep on the street.
Most of us would accept that a minimum condition of development is that the physical (or material)
quality of life is high and that it is evenly extended (not that only a minority does benefit of these
conditions). We could also include political freedoms and rights, intellectual and cultural development, a
low crime rate, etc. Is a high level of material well-being accessible to all a necessary condition for other
types of progress? Does GDP per capita reflect the material well-being of a country? We all probably accept
that development is not just about income, although income has a lot to do with it.
Two visions:
1. Development has a “multidimensional” characteristic: it is also the elimination of poverty and
malnutrition; it is an increase in life expectancy; it is access to the sanitation network, drinking water
and health services; is the reduction of infant mortality; is greater access to education, etc. It could be
that the correlation between GDP and other desired aspects of development is not automatic (or does
not exist).
2. The fundamental features of development (health, life expectancy, literacy, etc.) come from the growth
of GDP per capita aggregate economic forces have the power to positively influence all other socio-
economic aspects.
Is it possible to find a relatively small set of variables perfectly correlated with the multidimensional
process of development? Income may not capture all aspects of development, but assuming that no
variable can account for the complex nature of development is not very helpful. To believe that
development is fueled exclusively by income is taking things too far, but it has the advantage of trying to
reduce a large set of issues to a smaller set, using economic theory. So, it could be a good proxy.
It makes sense to begin by studying what happens to the average levels of economic achievement (and
what are the forces that contribute to the growth of these average levels: GDP per capita) and to analyze
the influence of the distribution of economic achievement between the people of a country or region 
we must begin with the analysis of the evolution of per capita income and then move on to the distribution
of income.
2.7. Income evolution and inequality
We have already seen that not only are there very large differences in per capita income between
countries, but also that economic growth rates vary greatly between countries and periods. Three
observations:

 A significant proportion of countries shift in the ranking when long periods of time (several decades)
are considered, for example Argentina.
 There appears to be some symmetry between the upward and downward shifts, implying no change in
the global distribution taken or as a whole.
 Still, there are signs that low incomes are very persistent.
But differences between countries are not the only cause of inequality: there is also inequality (to a greater
or lesser degree) within countries, as we have already seen. If inequality indicators are used (% of income
corresponding to the poorest 40% of the population and the richest 20%) and they are related to income
p.c., what is observed is:
- The first indicator (between countries) decreases with income and then increases.
 - The second indicator increases with income (within) and then decreases. Therefore, it seems that
inequality within countries tends to increase among low-income countries and decrease as
intermediate income levels are exceeded (KUZNETS CURVE).
2.8. The HDI
The United Nations Development Program (UNDP) has published the Human Development Report since
1990. Its objective is to create a single index with some direct indicators of the state of the population in
terms of health, education, and nutrition, called the “Human Development Index” (HDI). The precursor was
"physical quality of life index" by Morris (1979), composed of three indicators: infant mortality, % of people
who know how to read and write, and life expectancy after the first year of life. There are three main
components of the HDI:
- Life expectancy at birth: it indirectly reflects infant and child mortality.
- The educational level of the society: it is a weighted average of the % of adults who can read and
write (2/3) and a combination of the enrollment rates in primary, secondary and tertiary education
(1/3).
- Per capita income: adjusted from a threshold (about $5,000 PPP in 1992). Less weight is given to
higher incomes, under the assumption that they have diminishing marginal utility.
The HDI is calculated by defining how a country's achievements in each component are measured and
taking a simple average of the three indicators. The transformation of a variable in an index between 0 y 1
x−min(x )
is used: índice=
max ( x )−min ⁡( x)

The HDI is the simple average of the following indexes:

¿−25
- Life expectancy index: LEI =
85−25
- Education index
AL−0
o Adult literacy index (2/3): ALI=
100−0
CGE−0
o Gross Enrolment Index (1/3): GEI=
100−0
GDP−100
- GDP Index: GDPI =
40.000−100
The result is a final figure for each country that takes a value between 0 and 1. It makes no sense to
compare the absolute values of the indicator: a figure of 0.90 compared to another of 0.45 does not mean
that the first country has well-being that is double that of the second. The rankings based on the HDI are of
interest. Also interesting is the comparison of the rankings according to the HDI and according to GDP p.c.
The country with the highest HDI out of 191 countries in 2021 is Switzerland with an HDI of 0.962, and the
lowest is South Sudan with an HDI of 0.385. Spain ranks 27th with an HDI of 0.905. The countries are
divided into very high HDI groups (from 1 to 66 which is Thailand), high HDI from 67 (Albania) to 115
(Vietnam), medium HDI, from 116 (Philippines) to 159 (Ivory Coast), and Low HDI, from 160 (Tanzania) to
191.
2.9. The relation between GDP and income per capita
The income p.c. (and even equality in its distribution) is not an unequivocal guarantee of success in human
development. But at the same time, it could be argued that GDP p.c. is a pretty good proxy for most
aspects of development. Is this true?
It is necessary to analyze how much explanatory power it has compared to other basic indicators. If three
developmental indicators are used (life expectancy at birth, infant mortality rate, and % of adults who can
read and write), the result is that income p.c. is closely correlated with development, especially among low
and middle-low-income countries we must start by looking at income p.c. and the causes of its variation
(theories of economic growth).