Economic Growth

The World Economy Total GDP: $31.5T GDP per Capita: $5,080 Population Growth: 1.2% GDP Growth: 1.7%

The World Economy by Region RegionGDPGDP per cap Pop Growth GDP Growth Sub-Saharan Africa $318B$4502.2%3.2% East Asia & Pacific $1.8T$950.9%6.7% Middle East & N. Africa $693B$2,2202%3.2% Europe & C. Asia $1.1T$2,160.1%4.7% South Asia $655B$4501.7%4.3% Latin America $1.7T$3,2801.5%-.5%

US vs. Europe United States GDP: $10.1T GPD/Capita: $35,500 Pop Growth:.9% GDP Growth: 2.1% European Union GDP: $6.6T GDP/Capita: $20,230 Pop Growth:.2% GDP Growth:.7%

High Income vs. Low Income Countries As a general rule, low income (developing) countries tend to have higher average rates of growth than do high income countries

Income vs. Growth IncomeGDP/CapitaPop Growth GDP Growth Low$4301.7%4.1% Middle$1,840.9%3.2% High$26,310.5%1.3%

High Income vs. Low Income Countries As a general rule, low income (developing) countries tend to have higher average rates of growth than do high income countries However, this is not always the case

Exceptions to the Rule Haiti GDP/Capita: $440 Pop Growth: 1.8% GDP Growth: -.9% Hong Kong (China) GDP/Capita: $24,750 Pop Growth:.8% GDP Growth: 2.3%

High Income vs. Low Income Countries As a general rule, low income (developing) countries tend to have higher average rates of growth than do high income countries However, this is not always the case So, what is Haiti doing wrong? (Or, what is Hong Kong doing right?)

Sources of Economic Growth Recall, that we assumed three basic inputs to production –Capital (K) –Labor (L) –Technology (A)

Growth Accounting Step 1: Estimate capital/labor share of income K = 30% L = 70%

Growth Accounting Step 1: Estimate capital/labor share of income K = 30% L = 70% Step 2: Estimate capital, labor, and output growth %Y = 5% %K = 3% %L = 1%

Growth Accounting Step 1: Estimate capital/labor share of income K = 30% L = 70% Step 2: Estimate capital, labor, and output growth %Y = 5% %K = 3% %L = 1% Productivity growth will be the residual output growth after correcting for inputs

Growth Accounting Step 1: Estimate capital/labor share of income K = 30% L = 70% Step 2: Estimate capital, labor, and output growth %Y = 5% %K = 3% %L = 1% Productivity growth will be the residual output growth after correcting for inputs %A = %Y – (.3)*(%K) – (.7)*(%L)

Growth Accounting Step 1: Estimate capital/labor share of income K = 30% L = 70% Step 2: Estimate capital, labor, and output growth %Y = 5% %K = 3% %L = 1% Productivity growth will be the residual output growth after correcting for inputs %A = %Y – (.3)*(%K) – (.7)*(%L) %A = 5 – (.3)*(3) + (.7)*(1) = 3.4%

Sources of US Growth Output Capital Labor Total Input Productivity

The Solow Model of Economic Growth The Solow model is basically a “stripped down” version of our business cycle framework (labor markets, capital markets, money markets) –Labor supply (employment) is a constant fraction of the population ( L’ = (1+n)L ) –Savings is a constant fraction of disposable income: S = a(Y-T) –Cash holdings are a constant fraction of income (velocity is constant)

The Solow Model Labor Markets –(w/p) = MPL(A,K,L) –L’ = (1+n)L –Y = F(A,K,L) = C+I+G

The Solow Model Labor Markets –(w/p) = MPL(A,K,L) –L’ = (1+n)L –Y = F(A,K,L) = C+I+G Capital Markets –r = (Pk/P)(MPK(A,K,L) – d) –S = I +(G-T) –K’ = K(1-d) + I

The Solow Model Labor Markets –(w/p) = MPL(A,K,L) –L’ = (1+n)L –Y = F(A,K,L) = C+I+G Capital Markets –r = (Pk/P)(MPK(A,K,L) – d) –S = I +(G-T) –K’ = K(1-d) + I Money Markets –M = PY

The Solow Model Step #1: Convert everything to per capita terms (For Simplicity, Technology Growth is Left Out) –x = X/L

Properties of Production Recall that we assumed production exhibited constant returns to scale Therefore, if Y = F(K,L), the 2Y = F(2K,2L) In fact, this scalability works for any constant

Properties of Production Recall that we assumed production exhibited constant returns to scale Therefore, if Y = F(K,L), the 2Y = F(2K,2L) In fact, this scalability works for any constant Y = F(K,L) (1/L)Y = F((1/L)K, (1/L)L) Y/L = F(K/L, 1) = F(K/L) y = F(k)

Properties of Production Recall that we assumed production exhibited constant returns to scale Therefore, if Y = F(K,L), the 2Y = F(2K,2L) In fact, this scalability works for any constant Y = F(K,L) (1/L)Y = F((1/L)K, (1/L)L) Y/L = F(K/L, 1) = F(K/L) y = F(k) MPL is increasing in k MPK is decreasing in k

Labor Markets w/p = MPL(k) and MPL is increasing in k y = F(k) = c + i + g L’ = (1+n)L

Capital Markets r = MPK(k) – d with MPK declining in k s = i + (g-t) = a(y-t) = a(F(k)-t) k’(1+n) = k(1-d) + i

The Solow Model Step #1: Convert everything to per capita terms (For simplicity, Technology Growth is left out) –x = X/L Step #2: Find the steady state –In the steady state, all variables are constant.

Steady State Investment In the steady state, the capital/labor ratio is constant. (k’=k) k’(1+n) = (1-d)k + i

Steady State Investment: In the steady state, the capital/labor ratio is constant. (k’=k) k’(1+n) = (1-d)k + i k(1+n) = (1-d)k + i

Steady State Investment In the steady state, the capital/labor ratio is constant. (k’=k) k’(1+n) = (1-d)k + i k(1+n) = (1-d)k + i Solving for i gives is steady state investment i = (n+d)k

Steady State Investment n =.20, d =.10

Steady State Output/Savings Given the steady state capital/labor ratio, steady state output is found using the production function y = F(k) Recall that MPK is diminishing in k

Steady State Output

Steady State Net Income (t=100)

Steady State Savings (a=.05)

In Equilibrium, (g-t)=0. Therefore, s=i

Steady State In this example, steady state k (which is K/L) is 50. Steady state investment (i) = steady state savings(s) = 15 Steady state output (y) equals F(50) = 400 Steady state government spending (g) = steady state taxes (t) = 100 Steady state consumption = y – g – i = 285 Steady state factor prices come from firm’s decision rules: –W/P = MPL(k), r = MPK(k) – d The steady state price level (P) = M/Y

Growth vs. Income Suppose that the economy is currently at a capital/labor ratio of 20.

In Equilibrium, (g-t)=0. Therefore, s=i

Growth vs. Income Suppose that the economy is currently at a capital/labor ratio of 20. –Investment = Savings = 7.5. This is higher than the level of investment needed to maintain a constant capital stock (6). –With the extra investment, k will grow. –As k grows, wages will rise and interest rates will fall.

Growth vs. Income Suppose that the economy is currently at a capital/labor ratio of 20. –Investment = Savings = 7.5. This is higher than the level of investment needed to maintain a constant capital stock (6). –With the extra investment, k will grow. –As k grows, wages will rise and interest rates will fall. Suppose the economy is at a capital/labor ratio of 70.

In Equilibrium, (g-t)=0. Therefore, s=i

Growth vs. Income Suppose that the economy is currently at a capital/labor ratio of 20. –Investment = Savings = 7.5. This is higher than the level of investment needed to maintain a constant capital stock (6). –With the extra investment, k will grow. –As k grows, wages will rise and interest rates will fall. Suppose the economy is at a capital/labor ratio of 70. –Investment = Savings = 6.5. This is less than the investment required to maintain a constant capital stock. –Without sufficient investment, the economy will shrink. –As k falls, interest rates rise and wages fall.

Growth vs. Income Poor (developing) countries (low capital/income ratio) are below their eventual steady state. Therefore, these countries should be growing rapidly Wealthy (developed) countries (high capital/labor ratio) are at or above their eventual steady state. Therefore, these countries will experience little or no growth.

Growth vs. Income Poor (developing) countries (low capital/income ratio) are below their eventual steady state. Therefore, these countries should be growing rapidly Wealthy (developed) countries (high capital/labor ratio) are at or above their eventual steady state. Therefore, these countries will experience little or no growth. The implication is that we will all end up in the same place eventually. This is known as absolute convergence

Growth vs. Income Poor (developing) countries (low capital/income ratio) are below their eventual steady state. Therefore, these countries should be growing rapidly Wealthy (developed) countries (high capital/labor ratio) are at or above their eventual steady state. Therefore, these countries will experience little or no growth. The implication is that we will all end up in the same place eventually. This is known as absolute convergence So, what’s wrong with Haiti?

Conditional Convergence Our previous analysis is assuming that every country will eventually end up at the same steady state. Suppose that this is not the case. For example, suppose that a country experiences a decline in population growth. How is the steady state affected?

A Decline in Population Growth

Conditional Convergence Our previous analysis is assuming that every country will eventually end up at the same steady state. Suppose that this is not the case. For example, suppose that a country experiences a decline in population growth. How is the steady state affected? With a lower population growth, the steady state increases from 50 to 85. With an increase in the steady state, this country finds itself further away from its eventual ending point. Therefore, growth increases. Conditional convergence states that a country’s growth rate is proportional to the distance from that county’s steady state

Another Example Suppose that savings rate in a country declines. How is the steady state effected?

A Decline in the Savings Rate

Another Example Suppose that savings rate in a country declines. How is the steady state effected? With a lower steady state (the steady state falls from 85 to 75), the country finds itself closer to its finishing point. Therefore, its growth rate falls.

Possible Income/Growth Combinations Growth LowHigh Income Low Haiti Dem.Rep.Congo Niger Zimbabwe Angola Bangladesh China Ghana High Canada Great Britain Germany France Hong Kong USA S. Korea Malaysia

Low Income/Low Growth Countries This combination is a symptom of a very low steady state. Therefore, the solution would be –Lower Population Growth –Higher Domestic Savings (Or Open up country to foreign savings)

Low Income/Low Growth Countries This combination is a symptom of a very low steady state. Therefore, the solution would be –Lower Population Growth –Higher Domestic Savings (Or Open up country to foreign savings) Another possibility could be the existence of barriers to capital formation –Encourage enforcement of property rights.

Low Income/Low Growth Countries This combination is a symptom of a very low steady state. Therefore, the solution would be –Lower Population Growth –Higher Domestic Savings (Or Open up country to foreign savings) Another possibility could be the existence of barriers to capital formation –Encourage enforcement of property rights. Foreign Aid?

High Income/Low Growth Countries These countries are probably nearing their (high) steady state. Therefore, recommendations would be: –Consider lowering size/scope of government –Promote the development of new technologies