Chapter 3 Growth and Accumulation Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley.

Objectives Identify the sources of long-run economic growth Examine the neoclassical model of economic growth Analyse the role of savings, investment and technology in the growth process Compare the pattern of growth between countries Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley.

3.2 Empirical Estimates of Growth 3.3 Neoclassical Growth Theory Chapter Organisation 3.1 Growth Accounting 3.2 Empirical Estimates of Growth 3.3 Neoclassical Growth Theory 3.4 Exogenous Technological Change 3.5 Convergence Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley

3.1 Growth Accounting Output grow through increases in inputs and increases in productivity. Growth accounting explains: The contribution of factors of production To the growth in total output. The production function is: Y = AF(K, N) (3.1) It shows the quantitative relationship between factor inputs and output. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley

Production Function Y = AF(K, N) (3.1) The production function shows that output is positively correlated with: The marginal product of labour (MPN) defined as Y/ N The marginal product of capital (MPK) defined as Y/ K Technology given by the parameter A. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley

Production Function Transforming Y = AF(K, N) to measure growth rates gives Equation (3.2): Y/Y = [(1 – θ) ☓ N/N] + (θ ☓ K/K) + A/A Capital share Output growth Labour share Technical progress labour growth capital growth Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley

Production Function Transforming Y = AF(K, N) to measure growth rates gives Equation (3.2): Y/Y = [(1 – θ) x N/N] + (θ x K/K) + A/A Output growth labour growth capital growth Labour share Capital share Technical progress Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley

Production Function Y/Y = [(1 – θ) x N/N] + (θ x K/K) + A/A (3.2) Equation (3.2) summarises the contribution of each input to the growth of output. The contribution of labour and capital to output equals: Their individual growth rates Multiplied by the share of that input towards output. The third term is total factor productivity (TFP), which measures the rate of technical progress. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley

Production Function The rate of growth per capita is a better indicator of standards of living and allows more accurate comparisons between countries. The growth accounting equation can be translated into per capita terms by subtracting population growth N/N from both sides. y/y = Y/Y = θ x k/k + A/A (3.4) Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley

Production Function y/y = Y/Y = θ x k/k + A/A (3.4) The parameter  usually has a value of 0.25 for Australia. Equation (3.4) suggests that a 1% increase in the amount of capital available to each worker will increase per capita output by 0.25 of 1%. The quantitative link is less than one because of diminishing returns to capital per capita. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley

Production Function Diminishing marginal returns occur when the incremental increases in inputs produces progressively less increases in output. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley

Chapter Organisation 3.1 Growth Accounting 3.2 Empirical Estimates of Growth 3.3 Neoclassical Growth Theory 3.4 Exogenous Technological Change 3.5 Convergence Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley

3.2 Empirical Estimates of Growth Empirical studies of growth have suggested that technical progress is also an important element in the growth process. Robert Solow estimated a growth equation for the US economy between 1909 and 1949. This equation indicated that the average annual growth in GDP was 2.9%. Of this, 0.32 was attributable to capital accumulation, 1.09% to increases in labour and 1.49% to technical progress. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley

Empirical Estimates of Growth The model of the production function assumes that capital and labour are the key determinants of growth. This ignores important factor inputs that also affect economic growth. Other possible factor inputs are: Human capital Natural resources Public infrastructure capital. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley

Empirical Growth Estimates Human capital is the individual’s investment in education and training which leads to increases in productivity. Incorporating human capital (H) into the production function gives: Y = AF(K, H, N) (3.5) It is important to distinguish labour endowment (N) from acquired human capital skills (H). Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley

Empirical Growth Estimates The natural resources of a country may give it an advantage which contributes to economic growth. Likewise, public sector investment in capital infrastructure can result in increased private sector productivity. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley

Chapter Organisation 3.1 Growth Accounting 3.2 Empirical Estimates of Growth 3.3 Neoclassical Growth Theory 3.4 Exogenous Technological Change 3.5 Convergence Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley

3.3 Growth Theory: The Neoclassical Model Neoclassical growth theory focuses on capital accumulation and its link to savings decisions. It highlights the role of technological advances in determining long-run growth. Growth theory attempts to explain: How economic decisions affect the accumulation of the factors of production Why some nations such as the US and Japan have grown rapidly over the past 150 years While other nations such as Bangladesh have experienced virtually zero growth. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley

Neoclassical Growth Theory Initially, neoclassical growth theory assumes there is no technical progress. This implies that the economy will reach a steady-state equilibrium. The steady-state equilibrium occurs at the point where pre capita variables do not change. At this point: Per capita GDP and per capita capital remain constant. Per capita capital cannot grow endlessly because of diminishing marginal product of capital. The economy, therefore, reaches a steady-state equilibrium. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley

Neoclassical Growth Theory Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley

Neoclassical Growth Theory The production function in Figure 3.3 shows the relationship between per capita output and the capital/labour ratio. As capital rises output rises, the marginal product of capital declines as more capital is added reflecting the diminishing marginal product of capital. The diminishing marginal product of capital provides the key to why economies reach a steady state. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley

Neoclassical Growth Theory In a steady state the level of investment required to maintain per capita capital depends on: Population growth (n = N/N) The depreciation rate (d). The economy needs investment to maintain the level of per capita capital: nk to provide capital for new workers dk to replace existing capital total investment requirement is (n + d)k Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley

Neoclassical Growth Theory The level of savings is the other link in the growth process. Assume: Constant population growth (n) and depreciation (d) A closed economy There is no government sector Savings are a constant fraction (s) of income (s is APS). Total per capita savings are therefore: sy = sf(k) The net change in capital per capita is: k= sy − (n+d)k (3.7) At the steady state the k = 0 Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley

Neoclassical Growth Theory These assumptions give: Steady-state equilibrium (y* and k*) Where per capita savings equals investment. sy* = sf(k*) = (n + d)k* (3.8) This relationship is represented in Figure 3.4. The saving relationship sf(k*) is the (concave to the k axis) production function. The investment relationship (n + d)k* is the straight ray from the origin. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley

Neoclassical Growth Theory Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley

Neoclassical Growth Theory Consider Figure 3.4. When saving exceeds investment required: sf(k0) > (n + d)k0 per capita capital increases from k0 to k*. Beyond point C: Diminishing MPK ensures savings are less than the required investment. sf(k0) < (n + d)k0 per capita capital decreases to k*. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley

Neoclassical Growth Theory The economy reaches a steady state at point C. This implies that steady-state growth rate is not affected by the level of savings. In the long run, an increase in the rate of savings: Raises the long-run level of capital and output per capita But not the growth rate of output. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley

Chapter Organisation 3.1 Growth Accounting 3.2 Empirical Estimates of Growth 3.3 Neoclassical Growth Theory 3.4 Exogenous Technological Change 3.5 Convergence Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley

3.4 Technological Change The preceding model adopted a very simplified view of economic growth over time in order to explain the relationships between per capita savings and capital per capita. It ignored the role of technology in promoting economic growth. Technology was assumed to be determined exogenously and remain constant for any given production function. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley

Technological Change We therefore allow technology to exogenously increase in the model. That is, A/A > 0 The function Y = AF(K, N) shows the technology effect as total factor productivity (TFP). An exogenous increase in technology causes the production function and savings function to shift upwards as in Figure 3.7. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley

Technological Change Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley

Technological Change The effect of exogenous increases in TFP on the neoclassical model is similar to an increase in savings. The new steady-state point is at an increasing per capita output and capital−labour ratio. However, the growth rate of per-capita output remains constant. It grows at the same constant TFP rate: Steady-state per capita incomes differ. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley

Technological Change The neoclassical growth model is an important reference. However, the model’s assumptions and validity have been questioned. Endogenous growth theory has been developed to allow for more complicated and realistic endogenous increases in Total Factor Productivity. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley

Chapter Organisation 3.1 Growth Accounting 3.2 Empirical Estimates of Growth 3.3 Neoclassical Growth Theory 3.4 Exogenous Technological Change 3.5 Convergence Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley

3.5 Convergence Neoclassical growth theory predicts that similar economies with equal rates of savings and population growth and the same access to technology will reach the same steady- state income. The model predicts absolute convergence for economies with: Equal rates of savings and population growth. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley

Convergence This model predicts conditional convergence for economies that differ in: Rates of savings Human capital development, or Population growth. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley

Convergence Empirical evidence is not conclusive. It suggests that some nations have shown: Divergence with poor countries growing slower than rich nations Absolute convergence for some nations with common characteristics Conditional convergence characteristics where steady state per capita incomes differ and growth rates in per capita income eventually equalise. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley