Lecture 7: Long-Run Growth L11200 Introduction to Macroeconomics 2009/10 Reading: Barro Ch.5 9 February 2010

Introduction Last time: – Conditional convergence: model in which economies converge to their own steady state k*, y* – Data provides much better support for this Today – Try to explain long-run positive growth

Problem Model predicts economy grows to a level of per capita GDP then stops growing Predicts growth rate falling over time as move towards steady state Data suggests steady growth rate: why?

Change in Structural Parameters One possibility: changes in s, n, δ: – Raising saving rate increases k*, y* steady state – But also raises current growth rate. – So continual increases in s would result in no decline in growth rate – Similarly continual decreases in n or δ would cause continual increases in growth rate – But little evidence for this

Non-diminishing marginal product Maybe assumption of diminishing marginal product is wrong – If marginal product is constant, then average product of capital doesn’t fall as k rises – Instead, we have constant growth rate – This is known as the ‘AK model’: but implausible that marginal product doesn’t diminish!

Technological progress Another possibility: continual technological progress – Similar to effect of continual increases in saving rate: consistent non-declining growth rate – More plausible that continual increase in saving rate. – So negative effect on growth of rising k is offset by positive effect on growth of technological progress shifting k* to the right

Endogenous Growth Theory Question: where does technological growth come from? – Much recent growth theory has focused on the origins of technological progress – Endogenous growth models focus on choice between investing in new capital versus investing in research and development (R&D)

Endogenous Growth Theory Adds an extra dimension to the model – Saving, s, can be directed towards new capital, or directed towards raising A. – So marginal product of capital investment vs marginal product of R&D investment is crucial. – Are there diminishing returns in R&D investment? – Central issue is ownership and control of R&D

Microeconomics of R&D Issue of incentives for R&D is central – If growth of A is driven by individual inventors / entrepreneurs then structure of intellectual property and patent law is central. – R&D has to diffuse through economy in order to raise general level of technology – But investors in R&D have to be protected from ‘rivals copying their ideas.

Summary so far We have now answered the key growth questions – Why economies grow at different rates, and exhibit different levels of GDP – What contributes to ‘long-term growth’ and explains steady growth rate of per capita GDP Next: turn to the question of fluctuations

Fluctuations In the growth model: – GDP growth is steadily converging to steady state, or growing due to technological improvements – Labour is continually employed in production In reality, in the short-term – Economy experiences negative growth rate – Labour experiences period of unemployment – How can we explain these fluctuations

Next Time: Fluctuations Begin to build a model of fluctuations – Call this a model of the ‘business cycle’ – Based on individual actions in work/leisure, consumption/saving – Then consider how agents respond to changes in technological progress – Test whether the model can explain the pattern of GDP growth, unemployment, inflation, interest rates we observe in the data.