1 MACROECONOMICS AND THE GLOBAL BUSINESS ENVIRONMENT Capital Accumulation, Technological Progress, and Economic Growth Copyright © 2005 John Wiley & Sons, Inc. All rights reserved. PowerPoint by Beth Ingram University of Iowa

4-2 Key Concepts Definition of Capital and Investment Decreasing Marginal Return Convergence in Rates of Growth The Steady State

4-3 Labor Hours Real GDP (billions of 1996 $) An increase in the quantity of labor increases Real GDP 1500 But growth rate decreases as labor increases Decreasing marginal product

4-4 Quantity of Capital Real GDP (billions of 1996 $) An increase in the quantity of capital increases Real GDP 1500 But growth rate decreases as capital increases Decreasing marginal product

4-5 Diminishing Marginal Return Growth will be fast when level of capital is low Growth slows down as capital accumulates Eventually, firms won’t add new capital – firms only replace depreciated capital Economy reaches a Steady State Growth Convergence The return from capital for developing countries should be higher (everything else held constant) than wealthy countries “Catch Up” (graph)

4-6 Optimal Investment Value of new capital is (Marginal Product) x (Price of Output) Suppose 6 units x $2 = $12 Cost of new capital Denoted by r+d r = interest rate  Assume resell capital and payoff principal d = wearing out of capital or depreciation Taxes may also be important Invest in new capital if Equilibrium: MP x Price of output = r If MP x Price of output > r…then keep investing in capital until equalized If MP x Price of output < r…put investment into financial market until equalized

4-7 In equilibrium… Interest Rate Percentage of Income 10% 5% 6% 12% Savings Investment 5%

4-8 In equilibrium… Interest Rate Percentage of Income 10% 5% 4% 14% Savings Investment

4-9 Suppose increase in TFP r Percentage of Income 10% 5% 6% 12% Savings Investment

4-10 Suppose declining savings Interest Rate Percentage of Income 10% 5% 5.5% 8% Savings Investment

4-11 Capital (K) Capital formation comes from Investment Capital is the total value of the machines and buildings used to produce output Capital depreciates (wears out) Assume constant rate of depreciation, d Assume depreciation is fraction of capital stock, d*K

4-12 Steady State The point where a country can no longer economically grow by adding more capital A resting point for capital stock Capital can temporarily deviate away, but always comes back A equilibrium point for the model Holding labor and productivity fixed Changes in the capital stock come from (1) new capital and (2) replacing old depreciated capital Gross investment = (1) + (2) Net Investment = (1) K t = K t-1 + I t + D t (Where D t = d*K t-1 and I t = b*Y t ; 0<d,b<1) Stead state: K t = K t-1 which implies I t = D t

4-13 Steady State Output Investment Capital Stock Real GDP Investment (20% of GDP) C + G + X - M

4-14 Steady State Output Investment Capital Stock Real GDP Depreciation = d x Capital Stock Investment = Depreciation

4-15 Depreciation exceeds investment; capital stock must increase Output Investment Depreciation Capital Stock Real GDP K ss K High K Low

4-16 Investment exceeds depreciation; capital stock must decline Output Investment Depreciation Capital Stock Real GDP K ss K High K Low

4-17 Implications Since capital is limited, growth must ultimately come from productivity If all countries eventually have same access to technology and other factors driving productivity then all countries should grow at the same rate Consequently, how much one country is investing will not affecting the growth rate i.e. in the long run, a country’s growth rate is independent of its investment Investment will, however, affect level of output

4-18 Increase in Investment Rate Output Investment (20% of GDP) Capital Stock Real GDP Depreciation Investment (30% of GDP) K 20% K 30%

4-19 The Asian Miracle Why did Asian economies grow so fast after 1950? Can this experience be repeated elsewhere?

4-20 Growth Accounting Asian Tigers,

4-21 Growth accounting in emerging markets, 1960–1994.

4-22 Growth Accounting

4-23 Does source of growth matter? Higher growth means higher standard of living Growth through capital accumulation Eventually dissipates Comes at a cost (low consumption in previous generations) Modern economies started industrializing around 150 years ago…why haven’t they reached their steady state? Transition to TFP-induced growth?

4-24 Capital Real GDP Effect of an increase in TFP K0K0 K1K1 Production Function, Old Production Function, New Investment, Old Investment, New Depreciation

4-25 Production Function Shift Summarizing Increase in Output due to function shift Increase in Labor Increase in TFP Increase in Output due to increase in capital Economy moves to new steady state As capital increases, output increases

4-26 TFP Institutions Property Rights Regulatory Institutions Macroeconomic Stabilization Social Insurance Conflict Management Political Rights Trust/Social Capital Culture of Risk Taking and Entrepreneurship Technology Gains

4-27 TFP Institutions: Caribbean Example 2007 World Bank report: Crime, Violence, and Development: Trends, Costs, and Policy Options in the Caribbean Crime, Violence, and Development: Trends, Costs, and Policy Options in the Caribbean

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4-32 TFP: Institutions Gone Awry ---Rent Seeking Activity in which value-added produced by one person is taken by another Examples U.S. Farm subsidies Concerns Absorbs resources (labor and capital) Rent seeking crowds out production Weakens social capital/breeds corruption

4-33 TFP: Technological Progress Another important driver in TFP not necessarily independent of institutions Growth can be sustained through technological progress Continued gains to productivity Role of Research and Development in promoting technological progress

GDP per Capita, 1997 R&D per Capita, 1997 TFP: Technological Progress Rich countries spend more on R&D

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4-36 Aside: Human Capital Capital can be broken down into physical and human capital Increase human capital means more output, even at current levels of physical capital and labor means higher steady state level of output and capital May explain some cross-country growth differentials

4-37 Aside: Human Capital Percentage of students completing the final year of primary school Source: World Bank Millennium Development Goals

4-38 Summary Marginal Product of Capital Implications of decreasing MPK Role in determining Steady State Steady State Investment Investment = Depreciation Growth can no longer be achieved through investment TFP Institutions Technological progress