I n t h I s c h a p t e r y o u w I l L

Ten Principles of Economics
presented in Chapter 1 is that people face
tradeoffs. This principle is especially important when considering the accumula-
tion of capital. Because resources are scarce, devoting more resources to producing
capital requires devoting fewer resources to producing goods and services for cur-
rent consumption. That is, for society to invest more in capital, it must consume
less and save more of its current income. The growth that arises from capital accu-
mulation is not a free lunch: It requires that society sacrifice consumption of goods
and services in the present in order to enjoy higher consumption in the future.
T
ECHNOLOGICAL PROGRESS LEADS TO
NEW PRODUCTS
, 
SUCH AS THIS HYBRID
ELECTRIC
/
GAS
-
POWERED CAR
, 
THAT
REDUCE OUR DEPENDENCE ON
NONRENEWABLE RESOURCES
.

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5 3 8
PA R T N I N E
T H E R E A L E C O N O M Y I N T H E L O N G R U N
The next chapter examines in more detail how the economy’s financial mar-
kets coordinate saving and investment. It also examines how government policies
influence the amount of saving and investment that takes place. At this point it is
important to note that encouraging saving and investment is one way that a gov-
ernment can encourage growth and, in the long run, raise the economy’s standard
of living.
To see the importance of investment for economic growth, consider Figure
24-1, which displays data on 15 countries. Panel (a) shows each country’s growth
rate over a 31-year period. The countries are ordered by their growth rates, from
most to least rapid. Panel (b) shows the percentage of GDP that each country
devotes to investment. The correlation between growth and investment, although
not perfect, is strong. Countries that devote a large share of GDP to investment,
such as Singapore and Japan, tend to have high growth rates. Countries that
devote a small share of GDP to investment, such as Rwanda and Bangladesh, tend
to have low growth rates. Studies that examine a more comprehensive list of coun-
tries confirm this strong correlation between investment and growth.
There is, however, a problem in interpreting these data. As the appendix
to Chapter 2 discussed, a correlation between two variables does not establish
which variable is the cause and which is the effect. It is possible that high invest-
ment causes high growth, but it is also possible that high growth causes high
(a) Growth Rate 1960–1991
(b) Investment 1960–1991
South Korea
Singapore
Japan
Israel
Canada
Brazil
West Germany
Mexico
United Kingdom
Nigeria
United States
India
Bangladesh
Chile
Rwanda
South Korea
Singapore
Japan
Israel
Canada
Brazil
West Germany
Mexico
United Kingdom
Nigeria
United States
India
Bangladesh
Chile
Rwanda
Investment (percent of GDP)
Growth Rate (percent)
0
1
2
3
4
5
6
7
0
10
20
30
40
F i g u r e 2 4 - 1
G
ROWTH AND
I
NVESTMENT
.
Panel (a) shows the growth rate of GDP per person for
15 countries over the period from 1960 to 1991. Panel (b) shows the percentage of GDP
that each country devoted to investment over this period. The figure shows that
investment and growth are positively correlated.

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C H A P T E R 2 4
P R O D U C T I O N A N D G R O W T H
5 3 9
investment. (Or, perhaps, high growth and high investment are both caused by a
third variable that has been omitted from the analysis.) The data by themselves
cannot tell us the direction of causation. Nonetheless, because capital accumula-
tion affects productivity so clearly and directly, many economists interpret these
data as showing that high investment leads to more rapid economic growth.
D I M I N I S H I N G R E T U R N S A N D T H E C AT C H - U P E F F E C T
Suppose that a government, convinced by the evidence in Figure 24-1, pursues
policies that raise the nation’s saving rate—the percentage of GDP devoted to
saving rather than consumption. What happens? With the nation saving more,
fewer resources are needed to make consumption goods, and more resources are
available to make capital goods. As a result, the capital stock increases, leading to
rising productivity and more rapid growth in GDP. But how long does this higher
rate of growth last? Assuming that the saving rate remains at its new higher level,
does the growth rate of GDP stay high indefinitely or only for a period of time?
The traditional view of the production process is that capital is subject to