CHAPTER EIGHT

Economic Growth II

macroeconomics

fifth edition

N. Gregory Mankiw

PowerPoint ® Slides prepared by Ming-Jang Weng

© 2002 Worth Publishers, all rights reserved

Chapter 8 Learning objectives

 Technological progress in the Solow model  Policies to promote growth  Growth empirics: Confronting the theory with facts  Endogenous growth: Two simple models in which the rate of technological progress is endogenous

CHAPTER 8

Economic Growth II slide 1

Introduction

In the Solow model of Chapter 7,   the production technology is held constant income per capita is constant in the steady state.

Neither point is true in the real world:  1929-2001: U.S. real GDP per person grew by a factor of 4.8, or 2.2% per year.  examples of technological progress abound (see next slide)

CHAPTER 8

Economic Growth II slide 2

Examples of technological progress

      1970: 50,000 computers in the world 2000: 51% of U.S. households have 1 or more computers The real price of computer power has fallen an average of 30% per year over the past three decades.

The average car built in 1996 contained more computer processing power than the first lunar landing craft in 1969.

Modems are 22 times faster today than two decades ago.

Since 1980, semiconductor usage per unit of GDP has increased by a factor of 3500.

1981: 213 computers connected to the Internet 2000: 60 million computers connected to the Internet

CHAPTER 8

Economic Growth II slide 3

Tech. progress in the Solow model

 A new variable:

E

= labor efficiency  Assume: Technological progress is labor-augmenting: it increases labor efficiency at the exogenous rate g:

g

 

E E CHAPTER 8

Economic Growth II slide 4

Tech. progress in the Solow model

 We now write the production function as:

Y

 )  where

L

 workers .

E

– = the number of effective Hence, increases in labor efficiency have the same effect on output as increases in the labor force.

CHAPTER 8

Economic Growth II slide 5

Tech. progress in the Solow model

 Notation:

y

=

Y/LE k

=

K/LE

= output per effective worker = capital per effective worker  Production function per effective worker:

y

= f(k)  Saving and investment per effective worker:

s y

= s f(k)

CHAPTER 8

Economic Growth II slide 6

Tech. progress in the Solow model

 Derivation of

the equation of motion for K

 

K

( net investment ) 

I

( gross investment )

K

( depreciation )

I



K

 

K

  

k k

Since 

k

  ( = 

K K

 )  (

K

 ) 

K

 ( )  

E



E

 

L

) 2 ( 

L L

 

E

)

E



g

), where 

L L



n

, and 

E E



g

 

k

 ( 

CHAPTER 8

Economic Growth II slide 7

Tech. progress in the Solow model

(  +

n

+ the amount of investment necessary to keep

g k

)

k

= break-even investment: constant. Consists of: 

k

to replace depreciating capital

n k

to provide capital for new workers

g k

to provide capital for the new “effective” workers created by technological progress

CHAPTER 8

Economic Growth II slide 8

Tech. progress in the Solow model

Investment, break-even investment 

k

= s f(k)  (  +

n

+

g

)

k

(  +

n

+

g

)

k sf(k) CHAPTER 8

Economic Growth II

k *

Capital per effective worker,

k

slide 9

Steady-State Growth Rates in the Solow Model with Tech. Progress

variable symbol Steady-state growth rate Capital per effective worker Output per effective worker Capital per worker k

= K/ (

L



E

)

y

= Y/ (

L



E

) ( K/ L ) =

k



E 0 0 g Output per worker

( Y/ L ) =

y



E Total output Y

=

y



E



L g n

+

g CHAPTER 8

Economic Growth II slide 10

The Golden Rule

To find the Golden Rule capital stock, express

c *

in terms of

k *

: In the Golden

c *

=

y *



i *

Rule Steady State,

c *

=

f

(

k *

) is maximized when MPK =  + 

n

( + 

g

+

n

+

g

)

k *

the marginal product of capital net of depreciation equals the pop. growth rate or equivalently, MPK   =

n

+

g

plus the rate of tech progress.

CHAPTER 8

Economic Growth II slide 11

Policies to promote growth

Four policy questions: 1.

2.

Are we saving enough? Too much? What policies might change the saving rate? 3.

4.

How should we allocate our investment between privately owned physical capital, public infrastructure, and “human capital”?

What policies might encourage faster technological progress?

CHAPTER 8

Economic Growth II slide 12

Are we saving enough? Too much?

Investment, break-even investment

f(k

*

) The saving rate, s’, is too high to reach the golden rule consumption.

s’f(k * ) s * f(k * ) c

*

gold CHAPTER 8 k

*

gold

Economic Growth II Capital per effective worker,

k

slide 13

1. Evaluating the Rate of Saving

 Use the Golden Rule to determine whether our saving rate and capital stock are too high, too low, or about right.  To do this, we need to compare (MPK   ) to (

n

+

g

).  If (MPK   ) > (

n

+

g

), then we are below the Golden Rule steady state and should increase

s

.  If (MPK   ) < (

n

+

g

), then we are above the Golden Rule steady state and should reduce

s

.

CHAPTER 8

Economic Growth II slide 14

1. Evaluating the Rate of Saving

To estimate (MPK   ), we use three facts about the U.S. economy: 1.

k

= 2.5

y

The capital stock is about 2.5 times one year’s GDP.

2.

3.



k

= 0.1

y

About 10% of GDP is used to replace depreciating capital.

MPK 

k

= 0.3

y

Capital income is about 30% of GDP

CHAPTER 8

Economic Growth II slide 15

1. Evaluating the Rate of Saving

1.

k

= 2.5

y

2.

3.



k

= 0.1

y

MPK 

k

= 0.3

y

To determine  , divided 2 by 1 : 

k k



y y

   

CHAPTER 8

Economic Growth II slide 16

1. Evaluating the Rate of Saving

1.

k

= 2.5

y

2.

3.



k

= 0.1

y

MPK 

k

= 0.3

y

To determine MPK, divided 3 by 1 : MPK

k



k



y y

 MPK   Hence, MPK   = 0.12  0.04 = 0.08

CHAPTER 8

Economic Growth II slide 17

1. Evaluating the Rate of Saving

 From the last slide: MPK   = 0.08

 U.S. real GDP grows an average of 3%/year, so

n

+

g

= 0.03

 Thus, in the U.S., MPK   = 0.08 > 0.03 =

n

+

g

 Conclusion:

The U.S. is below the Golden Rule steady state: if we increase our saving rate, we will have faster growth until we get to a new steady state with higher consumption per capita .

CHAPTER 8

Economic Growth II slide 18

2. Policies to increase the saving rate

 Reduce the government budget deficit (or increase the budget surplus)  Increase incentives for private saving:  reduce capital gains tax, corporate income tax, estate tax as they discourage saving  replace federal income tax with a consumption tax  expand tax incentives for IRAs (individual retirement accounts) and other retirement savings accounts

CHAPTER 8

Economic Growth II slide 19

3. Allocating the economy’s investment

 In the Solow model, there’s one type of capital.  In the real world, there are many types, which we can divide into three categories: – private capital stock – public infrastructure –

human capital

: the knowledge and skills that workers acquire through education  How should we allocate investment among these types?

CHAPTER 8

Economic Growth II slide 20

Allocating the economy’s investment:

two viewpoints

1.

Equalize tax treatment of all types of capital in all industries, then let the market allocate investment to the type with the highest marginal product.

2.

Industrial policy: Gov’t should actively encourage investment in capital of certain types or in certain industries, because they may have positive externalities (by-products) that private investors don’t consider.

CHAPTER 8

Economic Growth II slide 21

Possible problems with industrial policy

 Does the gov’t have the ability to “pick winners” (choose industries with the highest return to capital or biggest externalities)?

 Would politics (e.g. campaign contributions) rather than economics influence which industries get preferential treatment?

CHAPTER 8

Economic Growth II slide 22

4. Encouraging technological progress

 Patent laws: encourage innovation by granting temporary monopolies to inventors of new products  Tax incentives for R&D  Grants to fund basic research at universities  Industrial policy: encourage specific industries that are key for rapid tech. progress (subject to the concerns on the preceding slide)

CHAPTER 8

Economic Growth II slide 23

CASE STUDY:

The Productivity Slowdown

Canada France Germany Italy Japan U.K.

U.S.

Growth in output per person (percent per year) 1948-72 2.9

4.3

5.7

4.9

8.2

2.4

2.2

1972-95 1.8

1.6

2.0

2.3

2.6

1.8

1.5

CHAPTER 8

Economic Growth II slide 24

Explanations?

 Measurement problems Increases in productivity not fully measured.

– But: Why would measurement problems be worse after 1972 than before?  Oil prices Oil shocks occurred about when productivity slowdown began.

– But: Then why didn’t productivity speed up when oil prices fell in the mid-1980s?

CHAPTER 8

Economic Growth II slide 25

Explanations?

 Worker quality 1970s - large influx of new entrants into labor force (baby boomers, women).

New workers are less productive than experienced workers.  The depletion of ideas Perhaps the slow growth of 1972-1995 is normal and the true anomaly was the rapid growth from 1948-1972.

CHAPTER 8

Economic Growth II slide 26

The bottom line:

We don’t know which of these is the true explanation, it’s probably a combination of several of them .

CHAPTER 8

Economic Growth II slide 27

CASE STUDY:

I.T. and the “new economy”

Canada France Germany Italy Japan U.K.

U.S.

1948-72 2.9

4.3

5.7

4.9

8.2

2.4

2.2

Growth in output per person (percent per year) 1972-95 1.8

1.6

2.0

2.3

2.6

1.8

1.5

1995-2000 2.7

2.2

1.7

4.7

1.1

2.5

2.9

CHAPTER 8

Economic Growth II slide 28

CASE STUDY:

I.T. and the “new economy”

Apparently, the computer revolution didn’t affect aggregate productivity until the mid-1990s. Two reasons: 1. Computer industry’s share of GDP much bigger in late 1990s than earlier. 2. Takes time for firms to determine how to utilize new technology most effectively The big questions:   Will the growth spurt of the late 1990s continue? Will I.T. remain an engine of growth?

CHAPTER 8

Economic Growth II slide 29

A Nobel Laureate’s Words

I do not see how one can look at figures like these without seeing them as possibilities. Is there some action a government of India could take that would lead the Indian economy to grow like Indonesia’s or Egypt’s ? If so, what, exactly? If not, what is it about the “nature of India” that makes it so? The consequences for human welfare involved in questions like these are simply staggering: Once one starts to think about them, it is hard to think about anything else.

Robert E. Lucas, Jr., “On the Mechanics of Economic Development,” Monetary Economics , July 1988.

Journal of

CHAPTER 8

Economic Growth II slide 30

Growth empirics: Confronting the Solow model with the facts

Solow model’s steady state exhibits balanced growth - many variables grow at the same rate.  Solow model predicts Y/L same rate (

g

), so that K/Y and K/L grow at should be constant.  This is true in the real world. Solow model predicts real wage grows at same rate as Y/L , while real rental price is constant. Also true in the real world.

CHAPTER 8

Economic Growth II slide 31

Convergence

 Solow model predicts that, other things equal, “poor” countries (with lower Y/L and K/L ) should grow faster than “rich” ones.

 If true, then the income gap between rich & poor countries would shrink over time, and living standards “converge.”  In real world, many poor countries do NOT grow faster than rich ones. Does this mean the Solow model fails?

CHAPTER 8

Economic Growth II slide 32

Convergence

 No, because “other things” aren’t equal.  In samples of countries with similar savings & pop. growth rates, income gaps shrink about 2%/year.

 In larger samples, if one controls for differences in saving, population growth, and human capital, incomes converge by about 2%/year.  What the Solow model really predicts is conditional convergence - countries converge to their own steady states, which are determined by saving, population growth, and education. And this prediction comes true in the real world.

CHAPTER 8

Economic Growth II slide 33

Factor accumulation vs. Production efficiency

Two reasons why income per capita are lower in some countries than others: 1. Differences in capital (physical or human) per worker 2. Differences in the efficiency of production (the height of the production function) Studies:  both factors are important  countries with higher capital (phys or human) per worker also tend to have higher production efficiency

CHAPTER 8

Economic Growth II slide 34

GDP Per Capita

United States Bangladesh China Egypt India Indonesia Mexico South Korea Taiwan Tanzania Thailand U.S.S.R.

Zaire 1950 9,573 551 214 517 597 874 2,085 876 922 427 848 2,834 636 1990 Dollars 1992 21,558 720 430 1,927 1,348 2,749 5,112 10,010 11,590 604 4,694 4,671 407 Cumulative Growth, % 125.20

30.67

100.93

272.73

125.80

214.53

145.18

1,042.69

1,157.05

41.45

453.54

64.82

-36.01

Source: Angus Maddison,

Monitoring the World Economy

1820-1992 (Paris: Organization for Economic Cooperation and Development, 1995)

CHAPTER 8

Economic Growth II slide 36

Endogenous Growth Theory

 Solow model: – sustained growth in living standards is due to tech progress – the rate of technological progress is exogenous  Endogenous growth theory: – a set of models in which the growth rate of productivity and living standards is endogenous

CHAPTER 8

Economic Growth II slide 37

A basic model

 Production function: where

A Y

=

A K

is the amount of output for each unit of capital (

A

is exogenous & constant)  Key difference between this model & Solow:

MPK is constant here, diminishes in Solow

 Investment:

sY

 Depreciation: 

K

 Equation of motion for total capital: 

K

=

sY

 

K CHAPTER 8

Economic Growth II slide 38

A basic model



K

=

sY

 

K

 Divide through by

K



Y Y

 

K K

 and use

Y sA

  =

A K

, get:  If

s A

>  , then income will grow forever, and investment is the

“engine of growth.”

 Here, the permanent growth rate depends on

s

. In Solow model, it does not.

CHAPTER 8

Economic Growth II slide 39

Does capital have diminishing returns or not?

 Yes, if “capital” is narrowly defined (plant & equipment).  Perhaps not, with a broad definition of “capital” (physical & human capital, knowledge).  Some economists believe that knowledge exhibits

increasing

returns.

CHAPTER 8

Economic Growth II slide 40

A two-sector model

 Two sectors: – – manufacturing firms produce goods research universities produce knowledge that increases labor efficiency in manufacturing 

u

= fraction of labor in research (

u

is exogenous)  Mfg prod func:

Y

=

F

[

K

, (1-

u

)

E L

]  Research prod func: 

E

 Capital accumulation: 

K

=

g

(

u

)

E

=

sY

 

K CHAPTER 8

Economic Growth II slide 41

A two-sector model

 In the steady state, mfg output per worker and the standard of living grow at rate  E/E =

g

(

u

).

 Key variables: s: affects the level of income, but not its growth rate (same as in Solow model) u: affects level and growth rate of income  Question: Would an increase in

u

good for the economy? be unambiguously

CHAPTER 8

Economic Growth II slide 42

Three facts about R&D in the real world

1.

Much research is done by firms seeking profits.

2.

Firms profit from research because • new inventions can be patented, creating a stream of monopoly profits until the patent expires • there is an advantage to being the first firm on the market with a new product

3.

Innovation produces externalities that reduce the cost of subsequent innovation.

Much of the new endogenous growth theory attempts to incorporate these facts into models to better understand technological progress.

CHAPTER 8

Economic Growth II slide 43

Is the private sector doing enough R&D?

 The existence of positive externalities in the creation of knowledge suggests that the private sector is not doing enough R&D.  But, there is much duplication of R&D effort among competing firms.  Estimates: The social return to R&D is at least 40% per year.

Thus, many believe government should encourage R&D.

CHAPTER 8

Economic Growth II slide 44



Accounting for the Sources of Economic Growth

Production Function (CRTS)

Y

 

Increases in Capital and Labor



Y

   (

MPK



Y Y



Y Y

   

K

)  (

MPL

G

Y



K

I J 

K K

Capital' s share of output I K 

K K

 

Y

  

K Y



K

 ( 1   ) 

L L

  

L

) G

Y

 of output

L

Labor' s share I J 

L

I K 

L L L

( 1   ) is labor' s share.

Economic Growth II

CHAPTER 8

slide 45



Accounting for the Sources of Economic Growth

Production Function with Technology

Y

 

Technological Progress



Y Y

  

K K

 ) 

L L

 

A A

Growth in  output Contribution  of capital Contribution of labor  Growth in Total Factor Productivity The above is the

growth-accounting equation

.

CHAPTER 8

Economic Growth II slide 46

 

Accounting for the Sources of Economic Growth

Solow Residual



A A

 

Y Y

  

K K

 ( 1   ) 

L L

Δ A / A

is the change in output that cannot be explained by changes in inputs. Thus, productivity is computed as a residual amount of output growth that remains after we have accounted for the determinants of growth that we can measure. Indeed,

Δ A / A

the growth in total factor – that is, as the

is sometimes called the Solow residual

, after Robert Solow, who first showed how to compute it.

CHAPTER 8

Economic Growth II slide 47

Accounting for Economic Growth in the United States

(average percentage, %, increase per year) Years

  Output 

Y

Grow th /

Y

    Capital 

K

/

K



SOURCE OF GROWTH

( 1  Labor  ) 

L

/

L

 Total Factor Productivi ty 

A

/

A

1950-1960 3.5

1.1

0.8

1.6

1960-1970 1970-1980 1980-1990 1990-1996 4.1

3.1

2.9

2.2

1.2

0.9

0.8

0.6

1.3

1.6

1.3

0.8

1.7

0.5

0.8

0.8

1950-1996 3.2

0.9

1.2

1.1

Source: U.S. Department of Commerce, U.S. Department of Labor, and the author’s Calculations. The parameter

α

is set to equal 0.3.

CHAPTER 8

Economic Growth II slide 48

Growth in the Asian Tigers

%

GDP per capita growth TFP * growth Δ% labor force participation Hong Kong (1966-1991) 5.7

Singapore (1966-1990) 6.8

South Korea (1966-1990) 6.8

Taiwan (1966-1990) 6.7

2.3

0.2

1.7

2.6

38→49 27→51 27→36 28→37 Δ% secondary education or higher 27.2→71.4 15.8→66.3 26.5→75.0 25.8→67.6

*TFP: total factor productivity Source: Alwyn Young, “The Tyranny of Numbers: Confronting the Statistical Realities of the East Asian Growth Experience,”

Quarterly Journal of Economics

, August 1995.

CHAPTER 8

Economic Growth II slide 49

Chapter summary

1.

Key results from Solow model with tech progress   steady state growth rate of income per person depends solely on the exogenous rate of tech progress the U.S. has much less capital than the Golden Rule steady state 2.

Ways to increase the saving rate  increase public saving (reduce budget deficit)  tax incentives for private saving

CHAPTER 8

Economic Growth II slide 50

Chapter summary

3.

Productivity slowdown & “new economy”   Early 1970s: productivity growth fell in the U.S. and other countries. Mid 1990s: productivity growth increased, probably because of advances in I.T.

4.

Empirical studies   Solow model explains balanced growth, conditional convergence Cross-country variation in living standards due to differences in cap. accumulation and in production efficiency

CHAPTER 8

Economic Growth II slide 51

Chapter summary

5.

Endogenous growth theory: models that   examine the determinants of the rate of tech progress, which Solow takes as given explain decisions that determine the creation of knowledge through R&D

CHAPTER 8

Economic Growth II slide 52

Thanks for your attention!!

Dr. Weng

CHAPTER 8

Economic Growth II slide 53