1. Indonesia and Global Economy Determinants of Economic Growth Dr. Adrian Teja

2. Why Potential Economic Growth Matter? The value of business are closely related to the growth rate of economic activity. Growth in an economy’s productive capacity, measured by potential GDP, places a limit on how fast the economy can grow. The idea is that potential GDP is the maximum amount of output an economy can sustainably produce without inducing an increase in the inflation rate.potential GDP

3. Topics For Determinants of Long Term Economic Growth Production Function Capital Deepening vs Technological Progress Growth Accounting Extending Growth Accounting

4. Production Function Equation 1: Y = AF(K,L) Y denotes the level of aggregate output in the economy In the production function above, A is a multiplicative scale factor referred to as total factor productivity (TFP).total factor productivity (TFP) –Note that an increase in TFP implies a proportionate increase in output for any combination of inputs. Hence, TFP reflects the general level of productivity or technology in the economy. –The state of technology embodies the cumulative effects of scientific advances, applied research and development, improvements in management methods, and ways of organizing production that raise the productive capacity of factories and offices. The function F( ) embodies the fact that capital and labor can be used in various combinations to produce output. K is an estimate of the capital services provided by the stock of equipment and structures used to produce goods and services. L is the quantity of labor or number of workers or hours worked in the economy

5. Production Function 2 Cobb-Douglas Production Function Equation 2: F(K,L) = K α L 1–α The parameter α determines the shares of output (factor shares) paid by companies to capital and labor and is assumed to have a value between 0 and 1.

6. Cobb-Douglas Production Function Important Properties (1) Constant Return to Scale If all the inputs into the production process are increased by the same percentage, then output rises by that percentage. Under the assumption of constant returns to scale, we can modify the production function (Y = AF(K,L)) and examine the determinants of the quantity of output per worker. Multiplying the production function by 1/L gives Y/L = AF(K/L, L/L) = AF(K/L, 1) Defining y = Y/L as the output per worker or (average) labor productivity and k = K/L as the capital-to-labor ratio, the above expression becomes y = AF(k,1)

7. Cobb-Douglas Production Function Important Properties (1) Specifying the Cobb–Douglas production function in output per worker terms, where again lower case letters denote variables measured on a per capita basis, we get Equation (3) y = Y/L = A(K/L) α (L/L) 1–α = Ak α This equation tells us that the amount of goods a worker can produce (labor productivity) depends on the amount of capital available for each worker (capital-to-labor ratio), technology or TFP, and the share of capital in GDP (α). It is important to note that there are two different measures of productivity or efficiency in this equation. Labor productivity measures the output produced by a unit of labor and is measured by dividing the output (GDP) by the labor input used to produce that output (y = Y/L). TFP is a scale factor that multiplies the impact of the capital and labor inputs.

8. Cobb-Douglas Production Function Important Properties (2) Diminishing Marginal Productivity with respect to each individual input Marginal productivity is the extra output produced from a one-unit increase in an input keeping the other inputs unchanged. It applies to any input as long as the other inputs are held constant. For example, if we have a factory of a fixed size and we add more workers to the factory, the marginal productivity of labor measures how much additional output each additional worker will produce. Diminishing marginal productivity means that at some point the extra output obtained from each additional unit of the input will decline. To continue our example, if we hire more workers at the existing factory (fixed capital input in this case) each additional worker adds less to output than the previously hired worker does and average labor productivity (y) falls.

9. Cobb-Douglas Production Function Important Properties (2) The significance of diminishing marginal returns in the Cobb– Douglas production function depends on the value of α. A value of α close to zero means diminishing marginal returns to capital are very significant and the extra output made possible by additional capital declines quickly as capital increases. In contrast, a value of α close to one means that the next unit of capital increases output almost as much as the previous unit of capital. In this case, diminishing marginal returns still occur but the impact is relatively small. Note that the exponents on the K and L variables in the Cobb– Douglas production function sum to one, indicating constant returns to scale—that is, there are no diminishing marginal returns if both inputs are increased proportionately.

10. Capital Deepening vs Technological Progress

11. Group Assignment: Mini Case Study Country A is an advanced economy with $100,000 of capital available for each worker and thus a high capital- to-labor ratio. In contrast, Country B is a developing country with only $5,000 of capital available for each worker. What impact will the following developments have on the growth rate of potential GDP? 1.An increase in business investment in both countries 2.An increase in the amount of spending on university research in both countries 3.An elimination of restrictions in Country B on the inflow of foreign investment

12. Growth Accounting Equation 4: ΔY/Y = ΔA/A + αΔK/K + (1 – α)ΔL/L The growth rate of output equals the rate of technological change plus α times the growth rate of capital plus (1 – α) times the growth rate of labor. Because a 1 percent increase in capital leads to an α% increase in output, α is the elasticity of output with respect to capital. Similarly, (1 – α) is the elasticity of output with respect to labor. Thus, in the Cobb–Douglas production function, the exponents α and (1 – α) play dual roles as both output elasticities and the shares of income paid to each factor. Note that the impact of any unspecified inputs (e.g., natural resources) is subsumed into the TFP component. Data on output, capital, labor, and the elasticities of capital and labor are available for most developed countries. The rate of technological change is not directly measured and must therefore be estimated. The elasticities of capital and labor in the growth accounting equation are the relative shares of capital (α) and labor (1 – α) in national income and are estimated from the GDP accounts.

13. Case United States, the relative shares of labor and capital are approximately 0.7 and 0.3, respectively. This means that an increase in the growth rate of labor will have a significantly larger impact—roughly double—on potential GDP growth than will an equivalent increase in the growth rate of capital, holding all else equal. For example, because capital’s share in GDP in the US economy is 0.3, a 1 percent increase in the amount of capital available for each worker increases output by only 0.3 percent. An equivalent increase in the labor input would boost growth by 0.7 percent.

14. Growth Accounting Uses (1) Solow used the equation to estimate the contribution of technological progress to economic growth. Solow estimated the growth in TFP as a residual in the above equation by plugging in ∆Y/Y, ∆K/K, ∆L/L, and α and solving for ∆A/A. This residual measures the amount of output that cannot be explained by growth in capital or labor and can thus be regarded as progress in TFP.

15. Growth Accounting Uses (2) The growth accounting equation is used to empirically measure the sources of growth in an economy. In such studies, the growth accounting equation is used to quantify the contribution of each factor to long-term growth in an economy and answer such questions as the following: –How important are labor and demographic factors to growth? –What is the contribution of capital, and how important is capital deepening as a source of growth? –What is the impact of TFP? The growth accounting equation can be expanded by considering different forms of capital and labor inputs, such as human capital and knowledge capital, and by considering the quality of the inputs as well.

16. Growth Accounting Uses (3) The growth accounting equation is used to measure potential output. Potential GDP is estimated using ΔY/Y = ΔA/A + αΔK/K + (1 – α)ΔL/L with trend estimates of labor and capital and α estimated as one minus the labor share of GDP. The difficult task is estimating the growth rate of TFP, which, by definition, is a residual in the growth accounting equation. The standard methodology treats TFP as exogenous and estimates its growth rate using various time-series models.

17. Labor Productivity Growth Accounting Growth Rate in Potential GDP = Long Term Growth Rate of Labor Force + Long Term Growth Rate in Labor Productivity. If the labor force is growing at 1 percent per year and productivity per worker is rising at 2 percent per year, then potential GDP is rising at 3 percent per year.

18. Extending Production Function Equation 5: Y = AF(N,L,H,K IT,K NT,K P ) Raw materials: natural resources such as oil, lumber, and available land (N) Quantity of labor: the number of workers in the country (L) Human capital: education and skill level of these workers (H) Information, computer, and telecommunications (ICT) capital: computer hardware, software, and communication equipment (K IT ) Non-ICT capital: transport equipment, metal products and plant machinery other than computer hardware and communications equipment, and non- residential buildings and other structures (K NT ) Public capital: infrastructure owned and provided by the government (K P ) Technological knowledge: the production methods used to convert inputs into final products, reflected by total factor productivity (A)

19. Raw Material (Natural Resources) Impact of Natural Resources To Economic Growth Near Zero, WHY? What is Dutch Disease? What is Equitorial Grand Canyon?

20. Impact of Natural Resources To Economic Growth Near Zero, WHY? Country Percent of World Proved Oil Reserves: 1990 Real Per Capita GDP Growth (%) 1990–2010 Country Percent of World Proved Oil Reserves: 1990 Real Per Capita GDP Growth (%) 1990–2010 Saudi Arabia25.753.00 Germany0.041.60 Venezuela5.852.80 France0.021.45 Mexico5.642.65 New Zealand0.012.60 United States2.622.50 Pakistan0.014.35 China2.4010.45 Japan0.011.05 Nigeria1.605.25 Spain0.002.50 Indonesia0.824.60 Philippines0.003.85 India0.756.55 Taiwan0.005.14 Canada0.612.10 Botswana0.005.29 Egypt0.454.65 Ethiopia0.005.61 United Kingdom0.432.15 Hong Kong0.004.00 Brazil0.283.05 Ireland0.004.83 Argentina0.234.40 Kenya0.002.89 Australia0.173.20 Singapore0.006.45 Italy0.071.00 South Africa0.002.65 Turkey0.053.80 South Korea0.005.69% Peru0.044.85 Vietnam0.007.45% Sources: US Energy Information Administration (www.eia.gov)

21. Quantity of Labor How to Measure? How to Increase Quantity of Labor? What should government do to improve labor participation rate?

22. Population Data for Selected Countries (millions) 200020052010 Annual Growth (%) 2000–2010 France59.161.263.00.64 Germany82.282.381.6–0.07 Ireland3.84.04.51.71 Spain40.343.446.11.35 United Kingdom58.959.461.30.40 Russia146.7142.8142.9–0.26 Japan126.9127.8127.60.06 United States282.2295.6309.10.91 Mexico98.4103.9108.40.97 China1,267.41307.61341.40.57 India1,024.31,110.01,190.51.52 Source: OECD Stat Extracts.

23. Average Hours Worked per Year per Person in Selected Countries 1995200020052010 France1,6511,5911,5591,594 Germany1,5341,4731,4351,419 Greece2,1232,1212,0812,109 Ireland1,8751,7191,6541,664 Italy1,8591,8611,8191,778 Spain1,7331,7311,6881,663 Sweden1,6091,5741,6071,624 UK1,7431,7111,6761,647 Japan1,8841,8211,7751,733 South Korea2,6582,522,3642,193 Canada1,7611,7681,7381,702 US1,841,8321,7951,778 Mexico1,8571,8881,9091,866 Turkey1,8761,9371,9181,877 Source: OECD Stat Extracts.

24. Migration Ireland and Spain: Net Migration 2000–2007200820092010 Total 2000– 2010 Ireland357,08538,502–7,800–12,200375,587 Spain4,222,813460,221181,073111,2494,975,356 Source: OECD Stat Extracts.

25. Labor Force Data for Selected Countries (2010) Country Percent of Population under Age 15 Percent of Population over Age 65 Participation Rate: Male (%) Participation Rate: Female (%) France18.316.772.667.3 Germany13.121.082.371.5 Greece14.318.676.555.0 Ireland21.511.479.563.4 Italy14.120.073.551.5 Spain15.017.080.466.1 Sweden16.618.384.577.8 UK17.715.982.870.5 Japan13.322.793.868.5 US20.113.179.269.8 Mexico28.15.983.248.3 Turkey26.47.073.928.8 Source: OECD Stat Extracts.

27. Comparison of Labor Force Participation

28. Human Capital & Capital (ICT and Non ICT)

33. Business Investment as a Percentage of GDP ICT Percent of GDP Investment Percent of GDP 199020002008 1990200020082010 Developed Countries France2.63.73.2 21.519.521.119.1 Germany3.13.62.7 22.821.519.417.3 Ireland1.12.31.2 20.823.921.711.0 Italy2.42.82.1 22.020.321.120.2 Spain3.43.63.7 25.326.228.823.0 UK3.35.14.2 20.517.116.615.0 Australia3.65.54.6 23.622.029.427.6 Japan4.93.73.1 32.525.423.220.2 South Korea2.45.14.8 35.730.631.229.1 Singapore3.25.44.9 35.233.130.223.8 Canada2.83.93.6 21.319.222.622.2 US4.16.65.1 17.419.918.115.8 Developing Countries BrazilNA 14.018.320.719.3 ChinaNA 24.935.144.048.2 IndiaNA 21.824.334.936.8 MexicoNA 17.925.526.925.0 South AfricaNA 19.115.122.519.3 Source: OECD StatLink.

34. Research and Development as a Percentage of GDP in Selected Countries 199020002009 France2.32.2 Germany2.62.52.8 Ireland0.81.21.8 Italy1.21.01.3 Spain0.81.01.4 UK2.11.81.9 Australia1.31.52.2 Japan3.0 3.4 South Korea1.72.33.1 Singapore1.11.92.9 Canada1.51.92.0 US2.62.72.9 ChinaNA1.01.7 IndiaNA0.8 MexicoNA0.30.4 Source: OECD Stat Extracts.

36. Labor and Total Factor Productivity Growth in Hours Worked a (%) Growth in Labor Prod. (%) Growth in TFP (%) Growth Due to Capital Deepening (%) Growth in GDP (%) Productivity Level 2010; GDP per Hour Worked ($) Germany 53.6 1995–2005–0.31.60.90.71.3 2005–20090.2 0.1 0.4 Ireland 50.3 1995–20053.24.11.72.47.3 2005–2009–0.80.8–2.12.90.0 United States 60.3 1995–20050.92.40.91.53.3 2005–2009–0.81.5–0.52.00.7 Japan 40.7 1995–2005–1.02.10.41.71.1 2005–2009–1.30.8–0.61.4–0.5 South Korea 27.9 1995–20050.04.32.41.94.3 2005–2009–0.52.82.00.82.3 China 8.6 1995–20051.16.71.55.27.8 2005–20081.210.34.26.111.5 India 5.3 1995–20052.14.21.92.36.3 2005–20082.26.02.43.68.2 Brazil 10.4 1995–20052.10.3–0.30.62.4 2005–20082.02.9–0.53.44.9 Mexico 16.8 1995–20052.21.40.41.03.6 2005–20081.80.8–0.10.92.6 a Total hours worked is the preferred measure of labor quantity. However, this measure is not available for most developing countries (including China, India, Brazil, and Mexico). For these countries, total employment is used assuming that the change in total hours worked equals the change in employment. In this case, labor productivity is measured as output per worker, but for the developed countries labor productivity is output per hour. Source: Conference Board Total Economy Database.

37. Public Infrastructure What is Infrastructure? Why it is important?

38. http://buysellmines.blogspot.com/2014/05/indonesian-infrastructure-part-iv.html

44. Sources of Output Growth Contribution from: Labor QuantityLabor QualityNon-ICTICT CapitalTFPGrowth in GDP (%) Capital(%) Germany 1995–2005–0.20.10.30.20.91.3 2005–2009–0.60.10.50.30.10.4 Ireland 1995–20052.00.32.60.71.77.3 2005–2009–0.20.11.80.4–2.10.0 United States 1995–20050.60.30.70.80.93.3 2005–20090.1 0.5 –0.50.7 Japan 1995–2005–0.60.40.60.30.41.1 2005–2009–0.60.10.40.2–0.6–0.5 South Korea 1995–2005–0.50.81.10.52.44.3 2005–2009–0.70.00.80.22.02.3 China 1995–20050.50.24.51.11.57.8 2005–20080.30.25.51.34.211.5 India 1995–20051.00.22.70.51.96.3 2005–20081.10.13.70.92.48.2 Brazil 1995–20050.80.11.10.7–0.32.4 2005–20080.80.21.92.5–0.54.9 Mexico 1995–20051.20.21.40.4 3.6 2005–20081.10.11.30.2–0.12.6 Source: Conference Board Total Economy Database.

45. Group Assignment Explain and relate below model to Indonesia Economic Growth Srategy.