Chapter 1 The Facts to Be Explained

About Our Author… Copyright © 2005 Pearson Addison-Wesley. All rights reserved. 2

A World of Rich and Poor Source: Easterly and Levine (2001). Copyright © 2005

A Country of Rich and Poor Source: Easterly and Levine (2001). Copyright © 2005

Our Neighborhood of Rich and Poor Source: Easterly and Levine (2001). Copyright © 2005

Copyright © 2005 Pearson Addison-Wesley. All rights reserved. 7

Why Focus on GDP per Capita? Economic Development – the overall “well-being” of a society. Income per Person will be our proxy for “well-being. ” Income per Person is associated with many “goods. ” To take just a couple of examples… Copyright © 2005 Pearson Addison-Wesley. All rights reserved. 8

Trends in Infant Mortality, by Region Annual number of deaths to infants under age 1 per 1, 000 live births Source: UN, World Population Prospects: The 2004 Revision (medium scenario), 2005. Copyright © 2005 Pearson Addison-Wesley. All rights reserved. 9

Population Living on Less Than US $2 per Day 2002 Percent Source: World Bank,

A More Holistic Measure of Living Levels – the Human Development Index HDI = 1/3 (Income Index) + 1/3 (life expectancy index) + 1/3 (education index) • Income Index = log(GDP per cap) – log(100) log (40, 000) – log(100) • Life Exp Index = life exp - 25 85 – 25 • Educ Index = (2/3) * (adult literacy/100) + (1/3) * (school enrollment/100) Does this statistic do a better job at measuring “development? ” Copyright © 2005 Pearson Addison-Wesley. All rights reserved. 11

HDI vs. Income Source: Human Development Report (2005). Copyright © 2005 Pearson Addison-Wesley. All

What About Happiness? Copyright © 2005 Pearson Addison-Wesley. All rights reserved. 13

Can You “Buy” Happiness? Copyright © 2005 Pearson Addison-Wesley. All rights reserved. 14

Copyright © 2005 Pearson Addison-Wesley. All rights reserved. 15

Copyright © 2005 Pearson Addison-Wesley. All rights reserved. 16

Copyright © 2005 Pearson Addison-Wesley. All rights reserved. 17

Copyright © 2005 Pearson Addison-Wesley. All rights reserved. 18

Copyright © 2005 Pearson Addison-Wesley. All rights reserved. 19

Convergence vs. Divergence • Japan’s story implies that countries initally poor “converged” to living standards of the rich. True in general? Copyright © 2005 Pearson Addison-Wesley. All rights reserved. 20

Are Poor Countries Catching Up? Growth Rates vs. Per Capita Income for Currently Developed Countries, 1870 -1979 Growth rate (%) 3. 0 1. 0 0 Per capita income in 1870 (1975 dollars) 2, 000 Source: Barrow and Sala-i-Martin (1995). Copyright © 2005 Pearson Addison-Wesley. All rights reserved. 21

Income Relative to U. S. , 1988 GDP per Cap Relative to the U.

Copyright © 2005 Pearson Addison-Wesley. All rights reserved. 23

Growth Before 1820 • Growth was glacial (on average, 0. 01% before 1500, 0. 04% 1500 – 1700, 0. 07% 1700 – 1820)…. – “Ups and downs certainly. Visitations of plague, famine, and war. Golden intervals. But no progressive, violent change. ” • Income differences between countries were very small. • After 1820. some countries grew a lot, while others were left behind. Copyright © 2005 Pearson Addison-Wesley. All rights reserved. 24

Copyright © 2005 Pearson Addison-Wesley. All rights reserved. 25

World Economic History in One Picture Source: Clark (2005). Copyright © 2005 Pearson Addison-Wesley.

Copyright © 2005 Pearson Addison-Wesley. All rights reserved. 27

Measuring and Comparing GDP Using Purchasing Power Parity • Three Big Issues with Income – measuring it, comparing it over time, and comparing it across countries. – Measuring: Counting up all goods and services, multiply by respective prices, and add ‘em up. – Comparing Over Time: Due to inflation, need a base year to construct a price index (price of a basket of goods at one year) – Comparing Over Countries: Since countries use different currencies, why not just use official exchange rates? • Exchange rates very volatile • While traded goods tend to have same price, non-traded goods tend to be much cheaper in developing countries. Copyright © 2005 Pearson Addison-Wesley. All rights reserved. 28

Measuring and Comparing GDP Using Purchasing Power Parity Comparisons of GDP at market exchange rates systematically understate the relative income of developing countries. Copyright © 2005 Pearson Addison-Wesley. All rights reserved. 29

Copyright © 2005 Pearson Addison-Wesley. All rights reserved. 30

Problem from Book, pg. 26 Country Computers Ice Cream Price of Computers in Local Currency Price of Ice Cream in Local Currency U. S. 12 4 2 dollars 4 dollars China 3 1 1 yuan Computers can be traded, ice cream can not. a) Calculate the level of GDP per capita in each country, measured in its own currency. b) Calculate the market exchange rate between the currencies of the two countries. c) What is the ratio of GDP per capita in the U. S. to GDP per capita in China, using the market exchange rate? d) Calculate the purchasing power parity exchange rate between the two currencies (Hint: calculate the cost of a “basket” of goods for each country). e) What is the ratio of GDP per capita in the U. S. to GDP per capita in China, using the PPP exchange rate? Copyright © 2005 Pearson Addison-Wesley. All rights reserved. 31

Model vs Reality • In models, we assume what is exogenous and what is not. • With some relationships, this is clear (rain fall and crop height). • With most economic relationships, it is not (living standards, education, health, etc…). • Economics is a science because we can test these theories with data. Copyright © 2005 Pearson Addison-Wesley. All rights reserved. 32

General Issues with Economic Data • Interesting things are often unmeasurable (utility, social capital, …) • Comparison often difficult – countries collect info in different forms. • Biases of official agencies • Data is almost always observational, not experimental Copyright © 2005 Pearson Addison-Wesley. All rights reserved. 33

Correlation vs. Causation • Determining if x and y move together is easy • Corr coef: Σ (x – meanx) (y - meany)______ sqrt ( (x – meanx)2) • Determining if x causes y is much harder Copyright © 2005 Pearson Addison-Wesley. All rights reserved. 34

Examples 1) 2) 3) 4) 5) Every time I eat chocolate, it gives me acne. Recent studies have proven that watching too much violence on television leads to people being violent in real life. Researchers at the Aabo Akademi found that Finns who speak the language of their Nordic neighbors were up to 25 percent less likely to fall ill than those who do not. Most drug use occurs among the poor - this is because poverty causes people to engage in risky behavior, like abusing narcotics. Morality in this nation has worsened at the same time that adherence to traditional Christian beliefs has declined. Obviously, the latter has caused the former, so encouraging Christianity will ensure a return to traditional moral standards. Copyright © 2005 Pearson Addison-Wesley. All rights reserved. 35