Growth in a Closed Economy

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At any given moment, Juan’s ability to produce output is largely determined by his stock of physical capital, his human capital, and the state of technology in Solovenia. But, as time passes, the level of output in Solovenia can change through a variety of mechanisms. First, the capital stock in Solovenia can grow over time, as shown in Figure 6.4. Juan builds up his capital stock by saving. Since Juan is the only inhabitant, the amount he saves is equal to the national savings of Solovenia. It is the difference between his output (real GDP of Solovenia) and the amount he consumes. [***In a real economy, national savings also include the savings of government: we must add in the government surplus or subtract the government deficit, as appropriate.***]

Figure 6.4 Figure 6.4  

Increases in the capital stock lead to increases in output. If the capital stock in Solovenia increases between this year and next year, output also increases. Increases in the capital stock are one source of growth. 

The more that Juan saves today, the more he can build up his capital stock, and the higher his future standard of living will be. If Juan chooses to consume less today, he will have a higher living standard in the future. If Juan chooses to consume more today, he must accept that this means less consumption in the future. Economies, like individuals, can choose between eating their cake now or saving it for the future.

In making this decision, Juan weighs the cost of giving up a little bit of consumption today against the benefit of having a little bit more consumption in the future. The higher the marginal product of capital, the more future benefit he gets from sacrificing consumption today. Other things being equal, a higher marginal product of capital induces Juan to save more. Juan’s choice also depends on how patient or impatient he is. The more patient he is, the more he is willing to give up consumption today to enjoy more consumption in the future.

Increases in the amount of physical capital are one way in which an economy can grow. Another is through increases in human capital and technology. These shift the production function upward, as shown in ***Figure 6.5. Perhaps Juan sometimes has better ideas about how to do things. Perhaps he gets better with practice. Perhaps Juan spends some time trying to come up with better ways of producing things.

　

Figure 6.5 Figure 6.5  

Increases in human capital or technology lead to increases in output. Increases in technology, human capital, and the workforce, like increases in the capital stock, are a source of output growth. 

Through the accumulation of physical and human capital, and by improving the components of technology such as knowledge and social infrastructure, the output in Solovenia will grow over time. The combined effect of physical capital growth and improvements in technology is shown in ***Figure 6.6.

Figure 6.6 Figure 6.6  

Increases in capital, human capital, and technology all lead to increases in output. In general, economies grow because of increases in capital, technology, human capital, and the workforce.