1. THE THEORY OF ECONOMIC GROWTH 1

2. Questions How important is faster labor-growth as a drag on economic growth? How important is a high saving rate as a cause of economic growth? How important is technological and organizational progress for economic growth? How does economic growth change over time? Are there economic forces that will allow poorer countries to catch up to richer countries? 2

3. American Real GDP per Capita, 1800-2004 (in 2004 Dollars) 3

4. Long-Run Economic Growth We classify the factors that generate differences in productive potentials into two broad groups differences in the efficiency of labor how technology is deployed and organization is used differences in capital intensity how much current production has been set aside to produce useful machines, buildings, and infrastructure 4

5. The Efficiency of Labor The efficiency of labor has risen for two reasons advances in technology advances in organization Economists are good at analyzing the consequences of advances in technology but they have less to say about their sources 5

6. “1974” There was a slowdown in productivity growth from approximately 1974 to around 1990. This is associated with the ITC (information and communications technology) ‘revolution’. Slowdown causes: Measurement – inadequate accounting for quality improvements The legal and human environment – regulations for pollution control and worker safety, crime, and declines in educational quality. Oil prices – huge increases in oil prices reduced productivity of capital and labor, especially in basic industries Kondratiev cycles 1873-1890 steam power, trains, telegraph 1917-1927 electrification in factories 1948-1973 transistor

7. Capital Intensity There is a direct relationship between capital-intensity and productivity a more capital-intensive economy will be a richer and more productive economy 7

8. Standard Growth Model Also called the Solow growth model Consists of variables behavioral relationships (aka laws of motion) equilibrium conditions The key variable is labor productivity output per worker (Y/L) 8

9. Solow Growth Model Balanced-growth equilibrium the capital intensity of the economy (K/Y) is stable This necessitates that the economy’s capital stock and level of real GDP are growing at the same rate the economy’s capital-labor ratio is constant 9

10. Solow Growth Model After finding the balanced-growth equilibrium, we calculate the balanced-growth path if the economy is on its balanced-growth path, the present value and future values of output per worker will continue to follow the balanced-growth path if the economy is not yet on its balanced-growth path, it will head towards it 10

11. The Production Function The production function tells us how the average worker’s productivity (Y/L) is related to the efficiency of labor (h) and the amount of capital at the average worker’s disposal (K/L) 11 Cobb-Douglas production function

12. The Production Function  measures how fast diminishing marginal returns to investment set in the smaller the value of , the faster diminishing returns are occurring 12

13. The Cobb-Douglas Production Function for Different Values of  13

14. The Production Function The value of the efficiency of labor (h) tells us how high the production function rises a higher level of h means that more output per worker is produced for each possible value of the capital stock per worker 14

15. The Cobb-Douglas Production Function for Different Values of h {or E in this particular plot} 15

16. The Production Function: Example h = $10,000  = 0.3 K/L = $125,000 16

17. The Production Function: Example If K/L rises to $250,000 17  the first $125,000 of K/L increased Y/L from $0 to $21,334  the second $125,000 of K/L increased Y/L from $21,334 to $26,265

18. Saving, Investment, and Capital Accumulation The net flow of saving is equal to the amount of investment Real GDP (Y) can be divided into four parts consumption (C) investment (I) government purchases (G) net exports (NX = X - M) 18

19. Saving, Investment, and Capital Accumulation 19 The right-hand side shows the three pieces of total saving  household saving (S H )  government saving (S G )  foreign saving (S F )

20. Saving, Investment, and Capital Accumulation Let’s assume that total saving is a constant fraction (s) of real GDP 20 Therefore, it must be true that

21. Saving, Investment, and Capital Accumulation We will refer to s as the economy’s saving rate we will assume that it will remain at its current value as we look far into the future s measures the flow of saving and the share of total production that is invested and used to increase the capital stock 21

22. Saving, Investment, and Capital Accumulation The capital stock is not constant We will let K 0 will mean the capital stock at some initial year K 2015 will mean the capital stock in 2015 K t will mean the capital stock in the current year K t+1 will mean the capital stock next year K t-1 will mean the capital stock last year 22

23. Saving, Investment, and Capital Accumulation Investment will make the capital stock tend to grow Depreciation makes the capital stock tend to shrink the depreciation rate is assumed to be constant and equal to  23

24. Saving, Investment, and Capital Accumulation Next year’s capital will be 24 The capital stock is constant when

25. Saving, Investment, and Capital Accumulation Suppose that the economy has no labor force growth and no growth in the efficiency of labor if K/Y < s/ , depreciation is less than investment so K and K/Y will grow until K/Y = s/  if K/Y > s/ , depreciation is greater than investment so K and K/Y will fall until K/Y = s/  25

26. Saving, Investment, and Capital Accumulation Thus, if the economy has no labor force growth and no growth in the efficiency of labor, the equilibrium condition of this growth model is 26

27. Equilibrium with Just Investment and Depreciation 27 Capital Stock per Worker Output per Worker K/L  /s (assumes that  and E are constant) (the reciprocal of the capital-output ratio) The capital stock is growing because K/L >  /s The capital stock is shrinking because K/L <  /s Equilibrium

28. Saving, Investment, and Capital Accumulation Remember that, in this particular case, we are assuming that the economy’s labor force is constant the economy’s equilibrium capital stock is constant there are no changes in the efficiency of labor Thus, equilibrium output per worker is constant Now we will complicate the model 28

29. Steady States Steady state: y t, c t, and k t are constant over time Gross investment must 1. Replace worn out capital 2. Expand so the capital stock grows as the economy grows, nK t I t = (n + d)K t C t = Y t – I t = Y t – (n + d)K t c = f(k) – (n+d)k