1. 13–1 Copyright  2005 McGraw-Hill Australia Pty Ltd PowerPoint® Slides t/a Principles of Macroeconomics by Bernanke, Olekalns and Frank Chapter 13 Savings, Capital Formation and Comparative Economic Growth

2. 13–2 Copyright  2005 McGraw-Hill Australia Pty Ltd PowerPoint® Slides t/a Principles of Macroeconomics by Bernanke, Olekalns and Frank Chapter 13: Savings, Capital Formation and Comparative Economic Growth Savings, investment and economic growth The Solow–Swan model of economic growth Recent developments in the study of economic growth

3. 13–3 Copyright  2005 McGraw-Hill Australia Pty Ltd PowerPoint® Slides t/a Principles of Macroeconomics by Bernanke, Olekalns and Frank Saving, Investment and Capital Saving frees resources for investment, both public and private Investment adds to the capital stock A greater capital stock raises labour productivity and GDP per capita

4. 13–4 Investment and GDP per capita

5. 13–5 Copyright  2005 McGraw-Hill Australia Pty Ltd PowerPoint® Slides t/a Principles of Macroeconomics by Bernanke, Olekalns and Frank The Solow–Swan Growth Model Also referred to as ‘Neo-classical Growth Model’ Gives primary role to saving and capital formation Minor role to total factor productivity ‘Growth’ refers to growth in output per worker, which by implication extends to growth in GDP per capita

6. 13–6 Copyright  2005 McGraw-Hill Australia Pty Ltd PowerPoint® Slides t/a Principles of Macroeconomics by Bernanke, Olekalns and Frank The Production Function Again Y = Af (K, L) Rewrite this function in ‘per worker’ terms by dividing both sides by L Y/L = y = Af (k) where k = K/L GDP per worker rises with the stock of capital per worker

7. 13–7 Copyright  2005 McGraw-Hill Australia Pty Ltd PowerPoint® Slides t/a Principles of Macroeconomics by Bernanke, Olekalns and Frank Diminishing Returns to k Diminishing returns to capital accumulation apply The higher is the existing capital–labour ratio (k), the smaller is the increase in GDP per worker (y) when there is an increase in k

8. 13–8 Capital–Labour Ratio and Output

9. 13–9 Copyright  2005 McGraw-Hill Australia Pty Ltd PowerPoint® Slides t/a Principles of Macroeconomics by Bernanke, Olekalns and Frank Are There Limits to Growth? Yes, because at some point the capital stock becomes so large that all of the economy’s saving is devoted to equipping new workers at the existing capital–labour ratio, and to replacing that part of the capital stock which wears out, rather than to increasing the stock of capital per worker

10. 13–10 Copyright  2005 McGraw-Hill Australia Pty Ltd PowerPoint® Slides t/a Principles of Macroeconomics by Bernanke, Olekalns and Frank Three Types of Investment Physical capital wears out through depreciation and needs to be replaced by ‘replacement investment’ This form of investment needs to be distinguished from ‘new or net investment’ which refers to the investment over and above replacement which increases the size of the capital stock Gross Investment = Net Investment + Replacement Investment (Depreciation) Net Investment = Gross Investment – Depreciation

11. 13–11 Copyright  2005 McGraw-Hill Australia Pty Ltd PowerPoint® Slides t/a Principles of Macroeconomics by Bernanke, Olekalns and Frank ‘Investment’ in Growth Models In growth models, the terminology is slightly different ‘Replacement investment’ also includes the amount of new investment which is required to equip new workers with the same capital as existing workers ‘New investment’ refers to investment which increases the capital–labour ratio, k ‘Gross investment’ is said to be zero when the capital–labour ratio is constant, even though the stock of capital has increased

12. 13–12 Copyright  2005 McGraw-Hill Australia Pty Ltd PowerPoint® Slides t/a Principles of Macroeconomics by Bernanke, Olekalns and Frank Two Claims on Saving Before there can be net investment – an increase in capital per worker – and further growth, saving must be sufficient to meet two claims on it –First, new workers have to be equipped with enough capital that the capital–worker ratio does not fall –Second, a fraction of the capital stock which wears out (depreciates) each year and must be replaced

13. 13–13 Copyright  2005 McGraw-Hill Australia Pty Ltd PowerPoint® Slides t/a Principles of Macroeconomics by Bernanke, Olekalns and Frank Requirements for Growth When these two claims are just met by saving, the stock of capital per worker, k, remains constant: net investment is said to be zero and output per worker, y, remains constant When saving exceeds these two claims, k can increase: net investment is is said to be positive and y rises

14. 13–14 Copyright  2005 McGraw-Hill Australia Pty Ltd PowerPoint® Slides t/a Principles of Macroeconomics by Bernanke, Olekalns and Frank First Requirement for Constant k Suppose the existing capital–labour ratio is k To maintain a constant k in the face of growth in the labour force, the capital stock must grow at the same rate as the labour force, say n. This requires an increase in the capital stock of nK This is because, if Δ/K = n, Δ = nK, where Δ means the change in the capital stock

15. 13–15 Copyright  2005 McGraw-Hill Australia Pty Ltd PowerPoint® Slides t/a Principles of Macroeconomics by Bernanke, Olekalns and Frank Second Requirement Let the fraction of the capital stock which wears out be d So the required replacement investment is dK

16. 13–16 Copyright  2005 McGraw-Hill Australia Pty Ltd PowerPoint® Slides t/a Principles of Macroeconomics by Bernanke, Olekalns and Frank Total Requirements In the face of an increase in the labour force and depreciation, the gross investment which is required to maintain a constant capital–labour ratio is (n + d)K –nK to equip the entrants to the labour force –dK to offset depreciation

17. 13–17 Copyright  2005 McGraw-Hill Australia Pty Ltd PowerPoint® Slides t/a Principles of Macroeconomics by Bernanke, Olekalns and Frank Saving Puts a Ceiling on k and y Saving S finances replacement and net investment S = sY, where s is the average propensity to save Growth continues whenever the capital–labour ratio increases: when sY > (d + n)K Growth ceases whenever the capital–labour ratio remains constant: when sY = (d + n)K At this point there is zero net investment, and the capital–labour ratio and labour productivity are both constant The economy is in a ‘steady state’

18. 13–18 Copyright  2005 McGraw-Hill Australia Pty Ltd PowerPoint® Slides t/a Principles of Macroeconomics by Bernanke, Olekalns and Frank Meaning of the ‘Steady State’ Capital per worker, k, is constant so that output per worker, y, is also constant Below the ‘steady state’ k is rising so that y is also rising

19. 13–19 The Path to the ‘Steady State’

20. 13–20 Copyright  2005 McGraw-Hill Australia Pty Ltd PowerPoint® Slides t/a Principles of Macroeconomics by Bernanke, Olekalns and Frank Going Backwards An economy could lie beyond its steady state if the rate of growth of the labour force had accelerated, so that saving was now inadequate to equip new workers with the same capital as existing workers The capital labour ratio and income per capita would fall back to the steady state

21. 13–21 Going Backwards

22. 13–22 Copyright  2005 McGraw-Hill Australia Pty Ltd PowerPoint® Slides t/a Principles of Macroeconomics by Bernanke, Olekalns and Frank Implications of the Steady State An end to growth in living standards Convergence of living standards between rich and poor countries – but only if they have the same production functions and the same rates of saving and long-run labour force growth Poor countries will grow faster than those richer countries which have reached their steady state

23. 13–23 Copyright  2005 McGraw-Hill Australia Pty Ltd PowerPoint® Slides t/a Principles of Macroeconomics by Bernanke, Olekalns and Frank When is there Convergence? We need to compare countries with similar labour force growth rates and with similar production functions and degrees of ‘open-ness’ to the rest of the world Convergence is ‘conditional’

24. 13–24 Copyright  2005 McGraw-Hill Australia Pty Ltd PowerPoint® Slides t/a Principles of Macroeconomics by Bernanke, Olekalns and Frank Evidence of Convergence For high-income countries, there is an inverse relationship between the level of income and the growth rate This means that, among these countries, the relatively poorer ones are ‘catching up’ to the richer ones

25. 13–25 The Rich Converge

26. 13–26 Copyright  2005 McGraw-Hill Australia Pty Ltd PowerPoint® Slides t/a Principles of Macroeconomics by Bernanke, Olekalns and Frank Convergence and Openness Open economies tend to converge This is because their openness allows them to influence each others’ economies

27. 13–27 Convergence and Openness

28. 13–28 The World Is Not Converging

29. 13–29 Copyright  2005 McGraw-Hill Australia Pty Ltd PowerPoint® Slides t/a Principles of Macroeconomics by Bernanke, Olekalns and Frank Solow–Swan Model Just a Start Steady state not yet observed for rich countries Growth accounting tells us that investment and a rising capital–labour ratio are not the main ingredients in growth of living standards

30. 13–30 Copyright  2005 McGraw-Hill Australia Pty Ltd PowerPoint® Slides t/a Principles of Macroeconomics by Bernanke, Olekalns and Frank Endogenous Growth Models Key role for raising total factor productivity (TFP) Role of education and human capital in TFP Role of research and development (R&D) in TFP Role of patent protection in R&D Protection of property rights in general Role of political structure in protecting property rights and punishing policy failures All these factors are inter-related