Growth Facts Solow Growth Model Optimal Growth Endogenous Growth Economic Growth Growth Facts Solow Growth Model Optimal Growth Endogenous Growth

Readings Williamson, Ch 6, p 200-222 (Solow Growth) Williamson, Ch 7 (Endogenous Growth)

Table 6.1 Economic Growth in Eight Major Countries, 1870–2005

Growth Facts Before Industrial Revolution (1800) standards of living was very similar across countries. Large differences in per-capita incomes across countries appeared after IR. Positive correlation between per capita output and per capital investment. Negative correlation between per capita output and population growth. Rich countries: Convergence Poorest countries: No Convergence

Figure 6.2 Output per Worker vs. Investment Rate

Figure 6.3 Output per Worker vs. the Population Growth Rate

Figure 6.5 Convergence Among the Richest Countries

Figure 6.6 No Convergence Among the Poorest Countries

Questions: (1) What explains differences in economic growth and standard of living among countries? (2) How do factors like saving, population, and technology affect economic growth and productivity? (3) What does CE model say about optimal growth? (4) How does the accumulation of “human capital” contribute to economic growth? (4) Policy implications?

Two key variables of interest: (1) yt = Yt/Nt = output per person or average labor productivity. Also can measure standard of living. (2) ΔY/Y = growth rate of Y.

Solow Growth Model F(xK,xN) = xF(K,N) Robert Solow (MIT) – 1989 Nobel Winner A constant returns to scale production function says F(xK,xN) = xF(K,N) Notice that from CRTS production function we can write where kt = Kt/Nt.

Per-capita GDP (y) depends only on the capital–labor ratio (k). Competitive Market-Clearing: Yt = Ct + It Assume proportional aggregate saving- investment rate: (Yt - Ct)= It = sYt Population grows at rate n: Nt+1 = (1+n)Nt Population = Labor Force = Nt

Definition of (Net) Investment:  A steady state equilibrium is where k and y are constant (no pressure to change):

In the steady state k = K/N and y = Y/N are constant. Therefore * Dy = Dk = 0 *

Saving Rate (s) Increase s  increases k* and y* (i) Permanent increase in standard of living (y*) (ii) Temporary increase in economic growth. Productivity/Technology (z) Increase z  increases k* and y* (i) Perm increase in standard of living (ii) One time inc. in z  temp increase in economic growth. (iii) Sustained inc. in z  perm inc. in growth

Figure 6.15 Effect of an Increase in the Savings Rate on the Steady State Quantity of Capital per Worker

Figure 6.16 Effect of an Increase in the Savings Rate at Time T

Figure 6.23 Natural Log of the Solow Residual, 1948–2001

Population growth (n) increase n  decreases k* and y* (i) Permanent decrease in standard of living (ii) Permanent increase in economic growth Application – The convergence hypothesis: Economic growth and output per person in countries with similar levels of technology, savings and population growth should converge.

Application/Evidence * Growth convergence among developed countries. * Japanese/German “miracle” after WWII * Non-convergence among poor countries Explanation: Barriers to Technological Adoption. (i) Trade Restrictions (ii) Intellectual Property Rights / Monopolies

Figure 7.2 Convergence in Income per Worker Across Countries in the Solow Growth Model

Figure 7.3 Convergence in Aggregate Output Across Countries in the Solow Growth Model

Productivity Levels in Selected Countries

Figure 6.4 No Convergence Among All Countries

Figure 7.4 Differences in Total Factor Productivity

Optimal Growth How much should a growing economy consume and save? (i) What’s the “best” s? (ii) What’s the “best” k*? Two Responses: (1) Maximize Steady State Consumption (Solow Model) (2) Maximize PDV of discounted household utility. (Optimal Growth Model)

Solow - The Golden Rule Steady-state per capita consumption: OR Golden-Rule: The optimal kGR* maximizes c* “treat others (future generations) as you would like to be treated”: FOC 

Figure 6.17 Steady State Consumption per Worker

Policy Public policies to increase saving rate (s) (1) Reduce budget deficit (government spending) (2) Encourage private saving (IRA accounts, Social Security reform) Public policies to increase productivity (z) (1) Infrastructure (2) Human capital (R&D) (3) Industrial policies

The Optimal Growth Model – Modified Golden Rule Optimal Growth Model  Basic CE model w/ * exogenous/inelastic labor supply * representative consumer so all variables are already in per-capita terms. The saving rate (s) is endogenous in Optimal Growth Model. Recall that CE Model  Pareto Optimal

Social Planner’s Objective: subject to State Variable: Control Variable: Bellman Equation:

First Order Condition: Steady State (Modified Golden Rule): where b = 1/(1+r) and r is rate of time preference. Is this level of capital k*MGR accumulation socially optimal?

Social Efficiency (Solow Growth): Individual Efficiency (Optimal Growth): as steady state implies r* = rate of time preference = r. (i) n = r = r  kGR= kMGG  Dynamic Efficiency (ii) n > r = r  kGR < kMGR  over accumulation (iii) n < r = r  kGR > kMGR  under accumulation

Endogenous Growth Solow Model can only explain non-convergence via barriers to technological adoption. In Solow Model sustained growth is due to exogenous forces. Does not explain where growth comes from. Endogenous growth models attempt to explain economic growth from society’s choice of human capital accumulation: Human Capital = Stock of Knowledge and Skills

A Simple Example Definitions: Labor Supply = ut Education = (1-ut) Human Capital Stock = Ht Efficiency Units of Labor = utHt Real Wage per Efficiency Unit = wt Budget Constraint for t = 1,2: (BC)

Investment in Human Capital: (HC) Production Function: Representative Household: Given H1 and wt, max U(c1,c2, …) subject to (BC) and (HC).

Representative Firm: Maximize Pt = Yt – wtutHt. Market-Clearing: Yt = ct General Case: In a steady state equilibrium where ut = ut+1 = u, Output Growth = Consumption Growth = Human Capital Growth = b(1-u) – 1 > 0 if b(1-u) > 1.

Implications Sustained economic growth can be explained by endogenously by human capital accumulation. Higher rates of growth can be attained by (i) Greater time allocation to education (1-u) (ii) More efficient educational systems (b) Countries with identical u and b will experience same growth rate but levels of output and standard of living may never converge.

Figure 7.9 Growth and Education

Figure 7.10 Income per Worker and Education

Figure 7.8 No Convergence in the Endogenous Growth Model

Policy Implications: (i) There is a potential role for governments to subsidize education/worker retraining or encourage efficiency (increasing b / decreasing u). (ii) There are externalities to human capital accumulation  too little private investment. Private Marginal benefit = MC < Society Marginal Benefit

(iii) Optimal Human Capital Accumulation: * Social MB = MC * Short-Run Marginal Cost of Lost Consumption = Long Run MB of increased future consumption.

Figure 7.7 Effect of a Decrease in u on the Consumption Path in the Endogenous Growth Model