Economic Growth in the Long-run

Chapter 3

Economics of Global Business, 1st Edition, MIT Press Copyright © Rodrigo Zeidan 2018
 The three main divisions.
• True long-term prosperity: Institutions and political stability are
the necessary and sufficient conditions for countries to become rich.
• Long-run growth: It comes from potential growth, or the efficient
use of resources. The supply side of the economy is more important.
Innovation, new industries, and human capital are key drivers.
• Short-run growth: Demand factors determine the GDP growth of
the current year. Behavior of consumers, companies, and government
spending, coupled with foreign demand for a country’s goods and
services, influence the path of the economy in the next few quarters.
Growth in the Long run: Overview
Economic growth across history.

• The Solow Model and how countries can achieve economic prosperity.

• China and Vietnam success stories.

• Endogenous Growth Theory and the role of ideas.

Longest-run Economic Growth
GDP per capita in year 2000 international $ dollars

Source: Maddison,
2001.
N
o 68
t
 The Middle-Income Trap?

Felipe et al (2016) The People’s Republic of China's Potential Growth Rate: The Long-Run Constraints
 Not Just Culture

S
i
m
i
l
a
r
c
u
l
t
u 74
Source: Acemoglu, Introduction to Modern Economic Growth, 2009.
r
Institutions matter –
Same culture, diverging experience

GDP per capita in the

two Koreas

Source: Acemoglu, Introduction to Modern Economic Growth, 2009.

And, most importantly, growth matters

WHERE WAS REAL PER CAPITA OUTPUT HIGHER?

● Thailand or Myanmar in 1 960?

● Argentina or Canada in 1 900?
● India or Korea in 1 950?

76
Despite growth……
● Inequality across countries persists.
● Inequality among individuals in a given country widens.

● Only a little evidence of convergence of countries.

● Growth across globe very uneven.
Growth in the Long Run

Long run analysis: establishing the conditions for prosperity:

 What factors influence a country’s level of prosperity?
 Why do some countries never escape the middle income trap? Will China be
able to make the jump?
Three Observations about Long-term Growth
True long-term prosperity hinges on the country’s institutions and its political stability. They are the
necessary conditions for countries to become rich.

 Long-run growth stems from potential growth, or the efficient use of resources. The supply side
of the economy is more important. Innovation, new industries, and human capital are the key
drivers.

 Short-run growth is mostly determined by demand factors. They shape the GDP growth of the
current year. Behavior of consumers, companies, and government spending, coupled with
foreign demand for the country’s goods and services all influence the path of the economy in
the next few quarters.
Historic Economic Growth
 Prior to the Industrial Revolution, annual GDP per capita growth was glacial.

 Chinese GDP per Capita grew only 30% from 1 AD to 1 820.

 Since 1 800, real GDP per capita has increased over 1 4 times, but economic
growth around the world has been unequal.
Converging Vs. Diverging
● Australia: What went right? ● Argentina: What went wrong?
 The Bourgeois: virtuous or exploiters?
Deirdre McCloskey
"the assaults on the alleged vices of the bourgeoisie and capitalism after 1 848 made
an impossible Best into the enemy of an actual Good.”

“we have been and can be virtuous and commercial, liberal and capitalist,
democratic and rich.”

“The American bourgeoisie, beginning in the late 1 9th century, organized official and
unofficial apartheids. It conspired violently against unions. It supported the excesses
of nationalism. It claimed credit for a religious faith that had no apparent influence on
its behavior. Nowhere does being bourgeois ensure ethical behavior.”
 Australia Vs. Argentina
At the beginning of the 20th Century At the beginning of the 20th Century,
Australia was a poor country, but was Argentina was one of the richest
able to converge with the rest of the countries in the world. Instability,
world and is now a rich country. dictatorships, short-sighted economic
Australia has leveraged high levels of policies and corruption stalled and
foreign investment, low public debt, hurt argentina’s economy, and
free markets and capital flows, and argentina is now a middle-income
its trade relations with other country. Argentina has fallen back
Asia/pacific/oceania to develop from its original standing in the world
rapidly. as a wealthy country, a century ago.
Summing up
 Economic growth has picked up in the last 200 years.

 Long-run prosperity is based on institutions that enable (and somewhat

constrain) economic activity.

 Poverty has fallen all over the globe.

 Extreme poverty, in particular, has been greatly reduced in the last 40 years.

 All other outcomes (e.g. health and education) have also markedly improved.

 But not all countries converge.

 Chapter 3.2 The Solow Model

Growth in the Long Run

Economics of Global Business, 1st Edition, MIT Press Copyright © Rodrigo Zeidan 2018
Basis of our version of the Solow Model
For the economy to grow in the long run, aggregate supply factors are more
important than aggregate demand.

Solow Growth Model isn’t indicative of actual GDP, but rather its potential--the
level at which the economy would be if all production factors were used efficiently.
Solow Model Equation
Rapid economic growth since the
Y = f(K, AL, AN) Industrial Revolution is result of
accumulation of K and L, the
Y -economic output
exploitation of N, and the
A -an index of productivity (technology) improvement of A.

K -capital Because of the diminishing returns of

all factors of productions (K, L, N),
L -labor technological improvements are the
only way to increase GDP per capita
N -natural resources.
sustainably, because it allows for
better combinations of these factors
of production.
Assumptions of the present version of the model
 Marginal Productivity of any input is positive and diminishing.
 F(cK, cAL, cAN) = cF(K, AL, AN).
 Labor grows at rate l, productivity at rate g, and natural resources at rate r.
 All growth in l, g, and r is exogenous.
 No government.
Basic Progression of a Developing Country

Accumulation of labor, natural resources, and capital leads to growth-

->eventually, accumulation of factors of production slows, and
economic growth becomes more dependent upon A (technological
improvements).
Technological Improvements Are Key
Increases in potential output (especially for rich countries) are primarily
dependent on increases in productivity and technology, and less
dependent on accumulation of capital, labor and resources.
 Illustration of increasing importance of A as
countries become richer
Growth accounting -United States.
Period Annual Growth Rate of Contribution of

Y Y/L A K/L
1948-1973 4.0% 3.0% 1.8% 1.2%
1973-1995 2.7% 0.9% 0.1% 0.8%
1995-2000 4.2% 3.0% 1.9% 1.1%

Source: Brad DeLong, 2001.

Industrialization for Emerging Economies
 Industrialization has been key to China’s economic rise, particularly in the past
30 years.

 It was also a primary reason for the USA’s economic growth a century earlier.
Industrialization in the United States
Investing in Human Capital (not only industrialization)

Source: James Heckman.

 Chapter 3.3 Beyond the Solow Model

Economics of Global Business, 1st Edition, MIT Press Copyright © Rodrigo Zeidan 2018
Theory Vs. Actuality
Theory: Empirics:

 Poor countries converge through  Convergence is domestically and

accumulation of K, L, and internationally context dependent.
exploitation of N.  Investments in R&D and
 Investment in R&D and education still have to be
education leads to long-term effective and efficiently allocated
prosperity in rich countries. to spur true long-term growth.
 Productivity can rise unimpeded.  Productivity is lagging in rich
countries.
The Solow Model
The model also shows a wide range of other interesting results:
 Economies can grow because of accumulation of capital, the growth
in population and the exploitation of natural resources.
 Yet, because of diminishing marginal returns, economic output
cannot increase forever based solely on these factors.
 Without growth in technology (productivity), there can be no growth
in prosperity for rich countries.
 We need more.
 Chapter 3.4 Sustaining Productivity

Long-Term Growth

Economics of Global Business, 1st Edition, MIT Press Copyright © Rodrigo Zeidan 2018
How to sustain long-run growth?
 Growth is dependent on investment. Whether it be in capital, or human capital
(labor) or in research and development (improving technology).

 In the short run aggregate investment increases demand. As investments

mature, they increase the country’s productive capacity.

 Aggregate investment is facilitated by good institutions, a stable environment,

and rules that are transparent and enforceable etc.
What Affects Long-Term Growth
Good for Long-Term Prosperity Harms Long-Term Prosperity

 Strong Institutions  Poor or corrupt institutions

 Access to resources  Lacking resources
 Increased education  Low education
 Improvements in Doing Business  Incompetent bureaucracy
 Incentives for investment and  No reason for
innovation people/government/companies
 Productive population to invest
 Aging, unproductive population
Extractive Vs. Non-Extractive Regimes
Extractive Regimes: Non-Extractive Regimes

 Upward distribution of  “Greener”;

resources;  More egalitarian;
 Typically Authoritarian,  More equal distribution of
though don’t have to be; resources;
 Controlled by elites;  Typically less corrupt.
 Typically More Corrupt.
Doing Business (World Bank)

Pinelopi Koujianou Goldberg,

World Bank Chief Economist, 2018.
Doing Business (World Bank, 201 8)
Top Middle Lowest
1 New Zealand 76 Ukraine 181 Haiti
2 Singapore 77 Kyrgyz Republic 182 Congo, Dem. Rep.
3 Denmark 78 China 183 Afghanistan
4 South Korea 79 Panama 184 Central African Republic
5 Hong Kong 80 Kenya 185 Libya
6 United States 81 Botswana 186 Yemen
7 United Kingdom 82 South Africa 187 South Sudan
8 Norway 83 Qatar 188 Venezuela
9 Georgia 84 Malta 189 Eritrea
10 Sweden 85 Zambia 190 Somalia
Aggregate Supply

 Solow Model determines Aggregate Supply.

 Aggregate Supply (AS) represents Potential Output.
 Potential Output: what the economy can produce if it
uses all factors of production (K, L, N).
 We divide AS in two components: the elastic part
(growth happen without inflation increasing much)
and the inelastic part (when actual output reaches
potential, engendering inflationary pressure).
Aggregate Supply: Short-term Vs. Long-Term
 Initially: Price stickiness → more Price level
horizontal Aggregate Supply AS
curve, less susceptible to price
and wage changes.
 Near Potential output: AS Curve
becomes more vertical because
maximum potential output
cannot be exceeded.

Potential GDP GDP=Y

Aggregate Supply: Short-term Vs. Long-Term
Price level
AS

AS does not
change in
the short run.

GDP=Y
Potential
GDP
Aggregate Supply: Long-Term
Price level
AS AS’

As K,L,N and
A increase
over time, AS
increases.

GDP=Y
Potential Potential
GDP GDP
Measuring Potential Output is hard.
• Potential Output is not directly observable.
• Estimating potential output gives an important target for
policy makers.
Aggregate Supply

In poor countries that industrialize or otherwise reform their

institutions, AS can increase fast and even shift in the short run.

In rare instances (the mid 1 990s because of the Internet), AS can

shift to the right in developed economies.

Supply-shocks may cause AS to contract (currency devaluations,

energy or water rationing, the Oil Crises of the 1 970s).
 Chapter 3.5 Levels of Development

Economics of Global Business, 1st Edition, MIT Press Copyright © Rodrigo Zeidan 2018
 Two Dimensional Classification of Development
(for now)

Actual Levels of Development (Poor, middle-income, Position in the business cycle (Recession, static
and rich) and Dynamic)

● For now, income (GDP per capita) will determine ● Recessions typically not strong enough to
a country’s development knock countries back.
● GDP per capita isn’t a perfect description ● Majority of growth from dynamic “boom”
(Equatorial Guinea -massive oil reserves skew periods
GDP numbers) ● We expect lower growth from rich countries
● Over the long-run, countries trend upwards than middle income and poor countries
● Very few instances of countries falling ● National vs regional conditions (Detroit
backwards (Argentina, Venezuela) struggling while U.S.A. grows)
 9 Possible Combinations

Poor Middle-Income Rich

Recession – Burundi, Liberia (early Brazil (2015-16), United States

Negative GDP Growth 2010s) Venezuela (2008-2009)

Static (Stagnant?) - Angola, Congo Republic Russia (2014-2016) Japan (2014), Italy
0 - 2.5% GDP growth (2017) (2010s)

Dynamic – Rwanda, Tanzania China United States

> 2.5% growth) (2010s) (2017)
More Examples
 Financial systems,
Chapter 3.6 inequality, climate change
and long run growth
Implicit but Often Errant Assumptions for Solow
Model

 Financial markets are working properly and are not an

obstacle to long-term prosperity.
 Growth lifts all boats.
 Exploiting natural resources has no adverse
environmental effect.
Endogenous Growth Theory: How Innovation
Affects Growth
 While the Solow model views the factors that go into economics as
exogenous, the Endogenous Growth Theory views changes in the
factors of production as (shockingly, given the name of the theory)
endogenous, meaning within the control of those within the system.
 It emphasizes the importance of human capital, innovation, and
knowledge.
 Appendix Endogenous Growth
Theory and The Thirteenth
Five-Year Chinese Plan

Economics of Global Business, 1st Edition, MIT Press Copyright © Rodrigo Zeidan 2018
 Differences From Solow Model
Primary difference is that A (coefficient of technology) is not a fixed coefficient, but
rather determined by the creation of new products and services, or inventions

Also, g, or the coefficient of per capita productivity, is determined by the following

equation:

Where λ is the extent of marginal productivity as we add more researchers;

Φ is the effect of past innovations on current inventions; n is the growth rate of the
number of researchers.
As researchers increase, cumulative innovation increases
while marginal effect of researchers decreases
The Thirteenth Five-Year Chinese Plan
 Five-year plans were used by the USSR and China as their central planning
tool.
 Now, aspirational.
 China has moved from poverty to middle income status.
 In early plans, key variables were close to the Solow models. In the tenth five-
year old plan, 2001 to 2005, tasks were: optimize and upgrade the industrial
structure, strengthen China’s international competitiveness, build more
infrastructure facilities, and raise levels of urbanization.
 Now, productivity: five guiding principles are innovation, coordination, green
development, opening up, and sharing.