Macroeconomic Dynamics
Growth Theory
Economic Growth Theories
Central Questions:
– Why are some economies much richer than others?
– Why do real incomes increase over time?
1. The Solow growth model
• Implication of physical capital accumulation on economic growth
• Saving rates are exogenous as are other potential sources of growth e.g.
technological progress
2. Infinite-horizon and overlapping generation models
• Saving is endogenous and allowed to vary over time
3. Endogenous growth theory
• Endogenous technological progress
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Some basic facts about economic growth:
• Standards of living in industrialized economies have
increased dramatically over the centuries
– In the U.S and Western Europe real incomes is 10 – 30 times larger
than 100 years ago and 50 – 300 times larger than 200 years ago
• Worldwide growth has not been constant
– Average growth rates in industrialized countries were higher in the
twentieth century than in the nineteenth century, still growth rates
were higher in the nineteenth century than in the eighteenth
century…
• Productivity growth has slowed down
– In many industrialized countries annual growth in output per
person has slowed down since the 1970s
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Some basic facts about economic growth:
(cont..)
• Standards of living vary enormously across countries
– Real income is more than 20 times higher in the U.S than in
Bangladesh
• Large variations in growth rates
– Growth miracles, e.g. Japan,
– Growth disasters, e.g. Sub-Saharan Countries, Argentina
• Over the modern era, cross-country income differences has
widened – enormous differences in human welfare across
different part of the world.
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”Once one start to think about economic
growth, it is hard to think about
anything else.”
(Robert E. Lucas, 1988)
5
Growth Models
• Since sustainable economic development is not possible without
economic growth, understanding how economic growth is achieved is
crucial in the study of development economics.
• We cover three growth models, starting with the simplest.
- Harrod-Domar model
- Solow model
- endogenous growth model
• In studying these models, you should pay attention to how different
factors and parameters interact with each other to result in a certain
pattern of change in capital/output over time.
Harrod-Domar model
• Following the publication of Keynes's General Theory in 1936, some
economists sought to dynamize Keynes's short-run theory to investigate
the long-run dynamics of capitalist market economics. Roy Harrod (1939,
1948) and Evsey Domar (1946, 1947) independently developed theories
that relates an economy’s rate of growth to its capital.
• While Keynes emphasized the impacts of investment on aggregate
demand, H-D model emphasized how investment spending also increased
an economy’s productive capacity (a supply-side effect).
The Model
• Key assumptions: - some labor is unemployed
- capital is binding constraint on production and growth
- exogenous rate of labor force growth (n)
- a given technology exhibiting fixed factor proportion
(constant K/L).
- a fixed capital-output ratio (K/Y)
Harrod-Domar model
Harrod-Domar model
Harrod-Domar model
The Solow growth model
The Solow model focuses on four variables:
–Output (Y)
–Capital (K)
–Labour (L)
–Effectiveness of labour (A)
The Production function takes the form:
Y t F K t , At Lt
where t denotes time, which enters indirectly into the
production function through K, L and A.
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Some properties of the production function:
– Output changes over time only if input changes over time
– The amount of output obtained from a given quantities of
capital and labour rises over time only if there are
technological progress, i.e. the effectiveness of labour
increases over time.
– A and L enter multiplicatively into the model such that the
term AL is referred to as ‘effective labour’ meaning that
technological progress is labour-augmenting (Harrod-
neutral).
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Some critical assumptions regarding the
production function:
– CRS – doubling input doubles output (A held constant):
F cK , cAL cF K , AL c0
• Implicitly assumes that the economy is sufficiently large that
any gains from specialization has been exhausted
• Implicitly assumes that other production factors (e.g. land) is
relatively unimportant
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With CRS, an intensive form of the production
function is easily specified:
Set c 1/ AL
K
F K , AL
1 Y
F , 1
AL AL AL
Intensive form production function:
y f k
Y K
k
AL AL
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The intensive form production function is assumed
to satisfy the following conditions:
f 0 0
f(k)
f ' (k ) 0
f ' ' (k ) 0
limk 0 f ' ( k )
limk f ' ( k ) 0
k
Inada conditions
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Example:
Cobb-Douglas production function:
Y K ( AL )1
Y K ( AL )1 K
k
AL AL AL
y f (k ) k
First order condition: f ' (k ) k 1 0
Second order condition: f ' ' (k ) 1k 2
(1 )k 2 0
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The Evolution of the Inputs in to Production
Labour and knowledge (technology) is assumed to
grow at a constant rate over time:
L n L(t ) L(t ) L(0)e nt
A g A(t ) A(t ) A(0)e gt
where n and g are exogenously given constant growth
rates and a dot over a variable denotes a derivative
w.r.t time (L (t ) dL(t ) / dt).
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Output is used to either consumption or investment
(saving).
• The saving rate (s) is assumed to be constant and
exogenously given.
– For simplicity one can assume that 1 unit of investment is
equal to 1 unit of new capital.
• Existing capital depreciates at a rate δ.
These assumptions imply that the capital stock grows
according to:
K (t ) sY (t ) K (t )
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Since k(t)=K(t)/A(t)L(t), i.e. a function of K, L and A,
which are all functions of t, the chain rule applies and we
can find the intensive form of the capital growth equation
from
k (t ) k (t ) k (t )
k (t ) K (t ) L(t ) A(t )
K (t ) L(t ) A(t )
K (t ) K (t ) L (t ) K (t ) A (t )
A(t ) L(t ) A(t ) L(t ) L(t ) A(t ) L(t ) A(t )
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L (t ) A (t )
f k (t )
n g
Y (t )
Since L(t )
, and
A(t ) A(t ) L(t )
we can write
K (t ) sY (t ) K (t )
k (t ) k (t )n k (t ) g k (t ) n k (t ) g
A(t ) L(t ) A(t ) L(t )
Y (t )
s k (t ) nk (t ) gk (t )
A(t ) L(t )
sf k (t ) n g k (t )
Total investment Break-even investment
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The rate of change in the capital stock per unit of effective labour
is the difference between total investment per effective labour unit
and the amount of investment needed to keep the capital-to-
effective labour-ratio constant.
Hence, k 0
When sf k (t ) n g k (t ) (break-even investment)
sf(k) n g k
sf(k)
k* k
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Convergence
• Inada conditions imply that
– at k=0, MPK is very large, which implies that actual investment
is larger than break-even investment such that k 0
– At k , MPK is very small, implying that actual investment is
smaller than break-even investment such that k 0
• This implies that k converges to k* since actual investment
adds to the capital stock at k < k* but when k > k* the
capital-to-effective labour-ratio decreases since investments
are too small to cover depreciation and growth in effective
labour.
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Predictions of the Solow Model:
• Regardless of starting point, the economy converges to a balanced
growth path where all variables in the model grow at a constant
pace:
L / L n
A / A g
K / K n g
k / k 0
• Still output per labour (Y / L) and capital per labour (K / L) grows
at the same rate as labour productivity i.e. at rate g.
At the balanced growth path output per worker grows at
the same rate at technological progress.
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A change in the saving rate
sf(k)
When s increases to s’
n g k k* increases to k*’
s’f(k) The adjustment of k take some
sf(k)
time, during which the actual
investment exceeds break-even
investment implying that
k 0 during the transition
period between two balanced
k growth path.
k* k*’
When k 0 output per worker grows at rate g.
When k 0 output per worker grows faster than g since there is
also growth in capital per unit of effective labour. 24
Implications of an increase in the saving rate:
• A permanent increase in the saving rate results in a temporary
increase in the growth rate of output per worker.
• In the long run, a change in the saving rate has a level effect but
not a growth effect – as soon as the economy stabilizes at a new
balanced growth path the economy grows at the rate g.
• In the long run, technological progress is the only factor that
drives economic growth.
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An increase in the saving rate
An increase in the saving rate raises investment…
…causing k to grow toward a new steady state:
Investment
and k
depreciation s2 f(k)
s1 f(k)
k
k 1* k 2*
Prediction:
• Higher s higher k*.
• And since y = f(k) ,
higher k* higher y* .
• Thus, the Solow model predicts that countries with
higher rates of saving and investment
will have higher levels of capital and income per
worker in the long run.
The transition to the
Golden Rule steady state
• The economy does NOT have a tendency to
move toward the Golden Rule steady state.
• Achieving the Golden Rule requires that
policymakers adjust s.
• This adjustment leads to a new steady state
with higher consumption.
• But what happens to consumption
during the transition to the Golden Rule?
Starting with too much capital
If k * k gold
*
then increasing c* y
requires a fall in s.
In the transition to c
the Golden Rule,
consumption is i
higher at all points
in time.
t0 time
Starting with too little capital
If k * k gold
*
then increasing c*
requires an y
increase in s.
c
Future generations
enjoy higher
consumption,
but the current i
one experiences
an initial drop
t0 time
in consumption.
The impact of population
growth
Investment,
break-even ( +n2) k
investment
( +n1) k
An increase in n
causes an sf(k)
increase in break-
even investment,
leading to a lower
steady-state level
of k.
k2* k1* Capital per
worker, k
CHAPTER 7
Economic Growth I
Impact of savings on consumption
Consumption per effective labour:
c 1 s y 1 s f (k )
On the balanced growth path we have
c* f ( k *) ( n g ) k *
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Whether an increase in saving leads to higher or lower levels of
consumption in the long run depends on the marginal product of
capital at the new balanced growth path:
if f ' (k *) (n g ) c*
if f ' (k *) (n g ) c*
if f ' (k *) (n g ) c 0
When the additional output from new capital is just sufficient to
maintain the existing capital stock – a marginal change in the saving
rate has no effect on consumption. This size of the capital stock
correspond to a long run equilibrium where consumption is
maximized for a given technological level!
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Golden rule level of capital stock
Long run consumption is maximized when the level of the capital
stock corresponds to a marginal product of capital that is equal to
the investment needed to keep the capital-to-effective labour-ratio
constant:
c* f (k *) (n g )k *
First order condition for maximized consumption:
c *
f ' (k *) (n g ) 0
k *
f ' (k *) (n g )
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The Solow model and the central questions of
growth theory
– Why are some economies much richer than others?
– Are income levels converging across nations?
The Solow model identifies two potential source to why output per
worker varies across countries and over time:
1. Differences in capital per worker (K / L)
2. Differences in the effectiveness of labour (A)
Due to convergence of k to k* changes in the effectiveness of labour is
the only factor that lead to permanent changes in the growth rate
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Convergence
– Are income levels converging across nations?
Three reasons why countries are expected to converge:
1. The model predicts that countries converge to their balanced growth
paths – to the extent that differences in output per worker depend on
countries being at different stages relative to their balanced growth
path, cross-country income differentials are expected to decrease.
2. The model predicts that the rate of return to capital is lower in
countries with more capital per worker, which induce capital to flow
from rich to poor countries and result in convergence.
3. Lags in technology diffusion can account for income differentials
between countries and to the extent that poor countries gain access to
state-of-the art technologies poor countries would catch up on rich
countries.
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Central conclusion from the Solow model:
Only differences in the productivity of labour can
account for vast differences in wealth across space
and time.
The ‘technology factor’ is, however, exogenous to the
Solow model – the model makes no prediction of what this
factor really is, how it behaves or how it grows.
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Endogenous Growth Theory
• Solow model:
– sustained growth in living standards is due to
technical progress
– the rate of technological progress is exogenous
• Endogenous growth theory:
– a set of models in which the growth rate of
productivity and living standards is endogenous
A basic model
• Production function: Y = A K
where A is the amount of output for each
unit of capital (A is exogenous & constant)
• Key difference between this model &
Solow: MPK is constant here, diminishes in
Solow
• Investment: sY
• Depreciation: K
• Equation of motion for total capital:
K = sY K
A basic model
K = sY K
Divide through by K and use Y = A K , get:
Y K
sA
Y K
If s A > , then income will grow forever,
and investment is the “engine of growth.”
Here, the permanent growth rate depends
on s. In Solow model, it does not.
Does capital have diminishing returns or
not?
• Yes, if “capital” is narrowly defined (plant &
equipment).
• Perhaps not, with a broad definition of
“capital” (physical & human capital,
knowledge).
• Some economists believe that knowledge
exhibits increasing returns.