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Economic Growth II:
Technology, Empirics, and Policy
9
CHAPTER
CHAPTER 9 Economic Growth II
Chapter 8 had a single focus: the in-depth development of the Solow model with population growth. In contrast, Chapter 9 is a survey of many growth topics. First, the Solow model is extended to incorporate labor-augmenting technological progress at an exogenous rate. This is followed by a discussion of growth empirics, including balanced growth, convergence, and growth from factor accumulation vs. increases in efficiency. Next, policy implications are discussed. Finally, the chapter presents two very simple endogenous growth models.
The models in this chapter are presented very concisely. If you want your students to master these models, have them do exercises and policy experiments with the models. In the book, the Problems and Applications at the end of the chapter are excellent for this purpose; consider assigning them as homework or use them in class to break up your lecture.
If you are pressed for time and are considering skipping this chapter, I encourage you to at least cover section 9-1, so that your students will learn the full Solow model with technological progress. One class period should be enough time to cover it, allowing for one or two in-class exercises if you wish. If you can spare a few more minutes, also consider section 9-3: it discusses policy implications, it’s not difficult or time-consuming, and students find it very interesting – it gives additional real-world relevance to the material in Chapter 8 and in Section 9-1.
IN THIS CHAPTER, YOU WILL LEARN:
how to incorporate technological progress in the Solow model
about policies to promote growth
about growth empirics: confronting the theory with facts
two simple models in which the rate of technological progress is endogenous
CHAPTER 9 Economic Growth II
Introduction
In the Solow model of Chapter 8,
the production technology is held constant.
income per capita is constant in the steady state.
Neither point is true in the real world:
1900–2013: U.S. real GDP per person grew by a factor of 8.3, or 1.9% per year.
examples of technological progress abound
(see next slide).
CHAPTER 9 Economic Growth II
Source: data used to construct Figure 1-1, and some simple calculations.
Examples of technological progress
U.S. farm sector productivity nearly tripled from 1950 to 2012.
The real price of computer power has fallen an average of 30% per year over the past three decades.
2000: 361 million Internet users, 740 million cell phone users
2015: 3.1 billion Internet users, 4.9 billion cell phone users
2001: iPod capacity = 5gb, 1000 songs. Not capable of playing episodes of Game of Thrones.
2015: iPod touch capacity = 64gb, 16,000 songs. Can play episodes of Game of Thrones.
CHAPTER 9 Economic Growth II
Students are certainly aware that rapid technological progress has occurred. Yet, it’s fun to show these figures, to take stock of some specific kinds of technological progress.
Sources:
U.S. Census Bureau
Wikipedia.org
The Economist, various issues
The Elusive Quest for Growth, by William Easterly
The Statistical Abstract of the United States at http://www.census.gov/prod/www/statistical_abstract.html
USDA: http://www.ers.usda.gov/Data/AgProductivity/
internet users: http://www.internetworldstats.com/stats.htm,
http://www.internetlivestats.com/internet-users/
cell phone users: gapminder.org, data originally from data.un.org, http://www.statista.com/statistics/274774/forecast-of-mobile-phone-users-worldwide/
Technological progress in the Solow model
A new variable: E = labor efficiency
Assume:
Technological progress is labor-augmenting:
it increases labor efficiency at the exogenous rate g:
CHAPTER 9 Economic Growth II
Technological progress in the Solow model
We now write the production function as:
where L × E = the number of effective workers.
Increases in labor efficiency have the
same effect on output as increases in
the labor force.
CHAPTER 9 Economic Growth II
Technological progress in the Solow model
Notation:
y = Y / LE = output per effective worker
k = K / LE = capital per effective worker
Production function per effective worker:
y = f(k)
Saving and investment per effective worker:
s y = s f(k)
CHAPTER 9 Economic Growth II
If your students have trouble wrapping their heads around quantities in “per effective worker” terms, tell them not to worry: it’s not exactly intuitive, it’s merely a mathematical device to make the model tractable.
Technological progress in the Solow model
(δ + n + g) k = break-even investment:
the amount of investment necessary
to keep k constant.
Consists of:
δ k to replace depreciating capital
n k to provide capital for new workers
g k to provide capital for the new “effective” workers created by technological progress
CHAPTER 9 Economic Growth II
The only thing that’s new here, compared to Chapter 8, is that gk is part of break-even investment.
Remember: k = K/LE, capital per effective worker. Tech progress increases the number of effective workers at rate g, which would cause capital per effective worker to fall at rate g (other things equal). Investment equal to gk would prevent this.
Technological progress in the Solow model
Investment, break-even investment
Capital per
worker, k
sf(k)
(δ+n +g ) k
k*
Δk = s f(k) − (δ +n +g)k
CHAPTER 9 Economic Growth II
The equation that appears above the graph is the equation of motion modified to allow for technological progress.
There are minor differences between this and the Solow model graph from Chapter 8:
Here, k and y are in “per effective worker” units rather than “per worker” units.
The break-even investment line is a little bit steeper: at any given value of k, more investment is needed to keep k from falling – in particular, gk is needed. Otherwise, technological progress will cause k = K/LE to fall at rate g (because E in the denominator is growing at rate g).
With this graph, we can do the same policy experiments as in Chapter 8. We can examine the effects of a change in the savings or population growth rates, and the analysis would be much the same. The main difference is that in the steady state, income per worker/capita is growing at rate g instead of being constant.
Steady-state growth rates in the
Solow model with tech. progress
n + g
Y = y × E × L
Total output
g
(Y/ L) = y × E
Output per worker
0
y = Y / (L × E )
Output per effective worker
0
k = K / (L × E )
Capital per effective worker
Steady-state growth rate
Symbol
Variable
CHAPTER 9 Economic Growth II
Table 9-1, p.245.
Explanations:
k is constant (has zero growth rate) by definition of the steady state
y is constant because y = f(k) and k is constant
To see why Y/L grows at rate g,
note that the definition of y implies (Y/L) = yE.
The growth rate of (Y/L) equals the growth rate of y plus that of E.
In the steady state, y is constant while E grows at rate g.
Y grows at rate g + n. To see this, note that Y = yEL = (yE)L. The growth rate of Y equals the growth rate of (yE) plus that of L. We just saw that, in the steady state, the growth rate of (yE) equals g. And we assume that L grows at rate n.
The Golden Rule with technological progress
To find the Golden Rule capital stock,
express c* in terms of k*:
c* = y* − i*
= f (k* ) − (δ + n + g) k*
c* is maximized when
MPK = δ + n + g
or equivalently,
MPK − δ = n + g
In the Golden
Rule steady state,
the marginal product of capital net of depreciation equals the
pop. growth rate plus the rate of tech progress.
CHAPTER 9 Economic Growth II
Remember: investment in the steady state, i*, equals break-even investment.
If your students are comfortable with basic calculus, have them derive the condition that must be satisfied to be in the Golden Rule steady state.
Growth empirics: Balanced growth
Solow model’s steady state exhibits
balanced growth—many variables grow
at the same rate.
Solow model predicts Y/L and K/L grow at the same rate (g), so K/Y should be constant.
This is true in the real world.
Solow model predicts real wage grows at same rate as Y/L, while real rental price is constant.
Also true in the real world.
CHAPTER 9 Economic Growth II
Check out the fourth paragraph on p.246: It gives a nice contrast of the Solow model and Marxist predictions for the behavior of factor prices, comparing both models’ predictions with the data.
Growth empirics: Convergence
Solow model predicts that, other things equal, poor countries (with lower Y/L and K/L) should grow faster than rich ones.
If true, then the income gap between rich & poor countries would shrink over time, causing living standards to converge.
In real world, many poor countries do NOT grow faster than rich ones. Does this mean the Solow model fails?
CHAPTER 9 Economic Growth II
Growth empirics: Convergence
Solow model predicts that, other things equal, poor countries (with lower Y/L and K/L) should grow faster than rich ones.
No, because “other things” aren’t equal:
In samples of countries with
similar savings & pop. growth rates,
income gaps shrink about 2% per year.
In larger samples, after controlling for differences in saving, pop. growth, and human capital, incomes converge by about 2% per year.
CHAPTER 9 Economic Growth II
Growth empirics: Convergence
What the Solow model really predicts is
conditional convergence—countries converge
to their own steady states, which are determined by saving, population growth, and education.
This prediction comes true in the real world.
CHAPTER 9 Economic Growth II
Growth empirics: Factor accumulation vs. production efficiency
Differences in income per capita among countries can be due to differences in:
1. capital—physical or human—per worker
2. the efficiency of production
(the height of the production function)
Studies:
Both factors are important.
The two factors are correlated: countries with higher physical or human capital per worker also tend to have higher production efficiency.
CHAPTER 9 Economic Growth II
The two reasons on this slide are both implied by the Solow model.
Growth empirics: Factor accumulation vs. production efficiency
Possible explanations for the correlation between capital per worker and production efficiency:
Production efficiency encourages capital accumulation.
Capital accumulation has externalities that raise efficiency.
A third, unknown variable causes
capital accumulation and efficiency to be higher in some countries than others.
CHAPTER 9 Economic Growth II
Policy issues
Are we saving enough? Too much?
What policies might change the saving rate?
How should we allocate our investment
between privately owned physical capital,
public infrastructure, and human capital?
How do a country’s institutions affect production efficiency and capital accumulation?
What policies might encourage faster technological progress?
CHAPTER 9 Economic Growth II
Policy issues:
Evaluating the rate of saving
Use the Golden Rule to determine whether
the U.S. saving rate and capital stock are
too high, too low, or about right.
If (MPK − δ) > (n + g ),
U.S. economy is below the Golden Rule steady state and should increase s.
If (MPK − δ) < (n + g ),
U.S. economy is above the Golden Rule steady state and should reduce s.
CHAPTER 9 Economic Growth II
This section (this and the next couple of slides) presents a very clever and fairly simple analysis of the U.S. economy.
When asked, students often have reasonable ideas of how to estimate MPK (e.g., look at stock market returns), n and g, but very few offer suggestions on how to estimate the depreciation rate: there are lots of different kinds of capital out there. Here, Mankiw presents a simple and elegant way to estimate the aggregate depreciation rate (which appears a couple of slides below).
First, though, you should make sure your students know why the inequalities in the last two lines tell us whether our current steady state is above or below the Golden Rule steady state.
To see this, remember that the steady-state value of capital is inversely related to the steady state value of MPK. If we’re above the Golden Rule capital stock, then we have “too much” capital, so MPK will be smaller than in the Golden Rule steady state. If we’re below the GR capital stock, then MPK is higher than in the Golden Rule.
Policy issues:
Evaluating the rate of saving
To estimate (MPK − δ), use three facts about the U.S. economy:
1. k = 2.5 y
The capital stock is about 2.5 times one year’s GDP.
2. δk = 0.1 y
About 10% of GDP is used to replace depreciating capital.
3. MPK × k = 0.3 y
Capital income is about 30% of GDP.
CHAPTER 9 Economic Growth II
The three equations appear in the top part of the next slide. Therefore, if you wish, instead of showing this slide, you could just explain orally what appears on this slide when you show the three equations on the next slide.
Policy issues:
Evaluating the rate of saving
1. k = 2.5 y
2. δk = 0.1 y
3. MPK × k = 0.3 y
To determine δ, divide 2 by 1:
CHAPTER 9 Economic Growth II
The actual U.S. economy has tens of thousands of different types of capital goods, all with different depreciation rates. Estimating the aggregate depreciation rate therefore might seem impossible.
But on this slide, we see Mankiw’s simple, clever, and elegant method of estimating the aggregate depreciation rate.
Pretty neat!
Policy issues:
Evaluating the rate of saving
To determine MPK, divide 3 by 1:
Hence, MPK − δ = 0.12 − 0.04 = 0.08
1. k = 2.5 y
2. δk = 0.1 y
3. MPK × k = 0.3 y
CHAPTER 9 Economic Growth II
Similarly, the method of estimating the aggregate MPK shown on this slide is far simpler and more elegant than somehow measuring and aggregating the returns on all different kinds of capital.
Policy issues:
Evaluating the rate of saving
From the last slide: MPK − δ = 0.08
U.S. real GDP grows an average of 3% per year,
so n + g = 0.03
Thus,
MPK − δ = 0.08 > 0.03 = n + g
Conclusion:
The U.S. is below the Golden Rule steady state:
Increasing the U.S. saving rate would increase consumption per capita in the long run.
CHAPTER 9 Economic Growth II
When the second bullet point displays on the screen, it might be helpful to remind students that, in the Solow model’s steady state, total output grows at rate n + g. Thus, we can estimate n + g simply by using the long-run average growth rate of real GDP.
Policy issues:
How to increase the saving rate
Reduce the government budget deficit
(or increase the budget surplus).
Increase incentives for private saving:
Reduce capital gains tax, corporate income tax, estate tax, as they discourage saving.
Replace federal income tax with a consumption tax.
Expand tax incentives for IRAs (individual retirement accounts) and other retirement savings accounts.
CHAPTER 9 Economic Growth II
If you have time available in class, you might consider asking students to brainstorm a list of policies or actions the government could take to increase the national saving rate.
If you’ve been reading these annotations in the “notes” area of these slides, you’ve seen my suggestions on generating classroom discussion, and hopefully have tried them. If you haven’t, now would be a great time to try, and it’s easy:
Get students into pairs (they need not change seats – students sitting together can work together). Ask them to take out a sheet of paper, and give them 3-4 minutes to see if they can come up with 3 different policies to increase saving. After the 3-4 minutes are up, ask for volunteers. Write down their responses on the board, and then compare the list that the class came up with to those appearing on this slide.
Having students work in pairs BEFORE discussing in class takes class-time, but yields many benefits.
All students become involved (while they are working in pairs), as opposed to only a few being involved if you immediately ask for responses w/o giving them time to think first.
Many students don’t have the confidence to volunteer a response when their instructor asks for responses immediately after posing the question. However, if these students are given a few moments to think of possible answers, and if they have the chance to run it by a classmate first, then they will be FAR more likely to volunteer their responses.
This leads to a higher quantity and quality of class participation.
Policy issues:
Allocating the economy’s investment
In the Solow model, there’s one type of capital.
In the real world, there are many types,
which we can divide into three categories:
private capital stock
public infrastructure
human capital: the knowledge and skills that workers acquire through education
How should we allocate investment among these types?
CHAPTER 9 Economic Growth II
Policy issues:
Allocating the economy’s investment
Two viewpoints:
1. Equalize tax treatment of all types of capital in all industries, then let the market allocate investment to the type with the highest marginal product.
2. Industrial policy:
Govt should actively encourage investment in capital of certain types or in certain industries, because they may have positive externalities
that private investors don’t consider.
CHAPTER 9 Economic Growth II
Refer students to the case study “Industrial Policy in Practice,” on pp.255-256.
Before showing the next slide, ask your students which of the two views is closest to their own.
Possible problems with
industrial policy
The govt may not have the ability to “pick winners” (choose industries with the highest return to capital or biggest externalities).
Politics (e.g., campaign contributions) rather than economics may influence which industries get preferential treatment.
CHAPTER 9 Economic Growth II
Policy issues:
Establishing the right institutions
Creating the right institutions is important for ensuring that resources are allocated to their best use. Examples:
Legal institutions, to protect property rights.
Capital markets, to help financial capital flow to the best investment projects.
A corruption-free government, to promote competition, enforce contracts, etc.
CHAPTER 9 Economic Growth II
Establishing the right institutions:
North vs. South Korea
After WW2, Korea split into:
North Korea with institutions based on authoritarian communism
South Korea with Western-style democratic capitalism
Today, GDP per capita is over 10x higher in S. Korea than N. Korea
CHAPTER 9 Economic Growth II
This satellite photo of North and South Korea was taken at night. South Korea is well-lit, indicating the widespread access to electricity. North Korea is dark.
For more info, see
Photo credit: Jason Reed/Reuters/Landov.
Policy issues:
Encouraging tech. progress
Patent laws:
encourage innovation by granting temporary monopolies to inventors of new products.
Tax incentives for R&D
Grants to fund basic research at universities
Industrial policy:
encourages specific industries that are key for rapid tech. progress
(subject to the preceding concerns).
CHAPTER 9 Economic Growth II
R&D = research and development
Average annual growth rates, 1970–89
closed
open
CASE STUDY:
Is free trade good for economic growth?
Since Adam Smith, economists have argued that free trade can increase production efficiency and living standards.
Research by Sachs & Warner:
0.7%
4.5%
developing nations
0.7%
2.3%
developed nations
CHAPTER 9 Economic Growth II
Interpreting the numbers in this table:
Sachs and Warner classify countries as either “open” or “closed.” Among the developed nations classified as “open,” the average annual growth rate was 2.3%. Among developed nations classified as “closed,” the growth rate was only 0.7% per year.
The average growth rate for “open” developing nations was 4.5%. The average growth rate for “closed” developing countries was only 0.7%.
See note 11 on p.260 for references.
CASE STUDY:
Is free trade good for economic growth?
To determine causation, Frankel and Romer exploit geographic differences among countries:
Some nations trade less because they are farther from other nations, or landlocked.
Such geographical differences are correlated with trade but not with other determinants of income.
Hence, they can be used to isolate the impact of trade on income.
Findings: increasing trade/GDP by 2% causes GDP per capita to rise 1%, other things equal.
CHAPTER 9 Economic Growth II
See note 11 on p.260 for references.
Endogenous growth theory
Solow model:
sustained growth in living standards is due to tech progress.
the rate of tech progress is exogenous.
Endogenous growth theory:
a set of models in which the growth rate of productivity and living standards is endogenous.
CHAPTER 9 Economic Growth II
In the Solow model, the long-run economic growth rate equals the rate of technological progress, which is exogenous in the model. Hence, the Solow model is basically saying “all I can tell you is that growth in living standards depends on technological progress. I have no idea what drives technological progress.”
Endogenous growth theory tries to explain the behavior of the rates of technological progress and/or productivity growth, rather than merely taking these rates as given.
The 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: δK
Equation of motion for total capital: ΔK = sY − δK
CHAPTER 9 Economic Growth II
This is an extremely simple model, yet has a powerful implication (to be developed below).
The basic model
ΔK = sY − δK
If s A > δ, 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.
Divide through by K and use Y = A K to get:
CHAPTER 9 Economic Growth II
Y and K grow at the same rate because A is constant.
Discussion:
The return to capital is the incentive to invest. If capital exhibits diminishing returns, then the incentive to invest decreases as the economy grows. Hence, investment cannot be a source of sustained growth.
However, in this model, MPK does not fall as K rises, so the incentive to invest never declines, people will always find it worthwhile to save and invest over and above depreciation, so investment becomes an engine of growth.
The $64,000 question:
Does capital exhibit diminishing or constant marginal returns? The answer is critical, for it determines whether investment explains sustained (i.e. steady-state) growth in productivity and living standards. See the next slide for discussion.
Does capital have diminishing returns or not?
Depends on definition of capital.
If capital is narrowly defined (only plant & equipment), then yes.
Advocates of endogenous growth theory
argue that knowledge is a type of capital.
If so, then constant returns to capital is more plausible, and this model may be a good description of economic growth.
CHAPTER 9 Economic Growth II
A two-sector model
Two sectors:
manufacturing firms produce goods.
research universities produce knowledge that increases labor efficiency in manufacturing.
u = fraction of labor in research
(u is exogenous)
Mfg prod func: Y = F [K, (1 − u )E L]
Res prod func: ΔE = g (u)E
Cap accumulation: ΔK = s Y − δK
CHAPTER 9 Economic Growth II
Before presenting this model, it might be helpful to tell students that it is an extension of something they already know – the Solow model with tech progress. There are two differences:
First, a fraction of the labor force does not produce goods & services, but rather produces “knowledge” by doing research in universities.
Second, the rate of tech progress is not exogenous, but rather depends on how fast the stock of knowledge grows, which in turn depends on how much labor the economy has allocated to research.
If you have a few minutes of class time after presenting the model, you should consider having your students work problem #7 on p.269. Otherwise, assign it as a homework exercise.
In regards to the specific elements of the model,
Manufacturing production function: Just like in the Solow model with exogenous technological progress, output of manufactures depends on capital and the effective labor force employed in the mfg sector, (1-u)EL.
Research production function: The “output” is increases in knowledge and
labor efficiency. The “inputs” are labor and current knowledge. The function g( ) shows how changes in the amount of labor devoted to research affect the creation of new knowledge. All we need is for g( ) to be an increasing function. It does not matter whether a doubling of scientists causes the creation of knowledge to double, more than double, or less than double.
Capital accumulation: Same as in the previous model — net investment equals gross investment (sY) minus depreciation.
A two-sector model
In the steady state, mfg output per worker and the standard of living grow at rate
ΔE / E = g (u ).
Key variables:
s: affects the level of income, but not its growth rate (same as in Solow model)
u: affects level and growth rate of income
CHAPTER 9 Economic Growth II
In this model, the steady state growth rate of the standard of living equals the growth rate of labor efficiency, just like in the Solow model with tech progress, covered at the beginning of this chapter. The difference here is that the rate of tech progress, g, is not exogenous: it depends on how much labor the economy has allocated to research.
DISCUSSION QUESTION
The merits of raising u
Question:
In what ways would raising u (i.e. devoting more labor to research) benefit the economy? What are the costs of raising u?
CHAPTER 9 Economic Growth II
Increasing u means devoting more resources to R&D. In the short run, output of goods & services per capita will fall. However, the pace of technological progress will rise, so growth will speed up and output per capita will eventually be higher than it would have been at the initial value of u.
Of course, if we increase u to its maximum possible value, 1, then no goods and services would be produced.
This tradeoff suggests that there must be some kind of golden rule for u,
a value of u that maximizes well-being per capita in the steady state.
At low enough values of u (values lower than this golden rule level), increases in u would, on balance, benefit the economy. At high enough values, increases in u would likely harm the economy.
Facts about R&D
1. Much research is done by firms seeking profits.
2. Firms profit from research:
Patents create a stream of monopoly profits.
Extra profit from being first on the market with a new product.
3. Innovation produces externalities that reduce the
cost of subsequent innovation.
Much of the new endogenous growth theory attempts to incorporate these facts into models to better understand technological progress.
CHAPTER 9 Economic Growth II
An excellent quote on p.264 is relevant to fact #3:
Isaac Newton once said “If I have seen farther than others, it is because I was standing on the shoulders of giants.”
Is the private sector doing enough R&D?
The existence of positive externalities in the creation of knowledge suggests that the private sector is not doing enough R&D.
But, there is much duplication of R&D effort among competing firms.
Estimates:
Social return to R&D ≥ 40% per year.
Thus, many believe govt should encourage R&D.
CHAPTER 9 Economic Growth II
Economic growth as “creative destruction”
Schumpeter (1942) coined term “creative destruction” to describe displacements resulting from technological progress:
the introduction of a new product is good for consumers but often bad for incumbent producers, who may be forced out of the market.
Examples:
Luddites (1811–12) destroyed machines that displaced skilled knitting workers in England.
Walmart displaces many mom-and-pop stores.
CHAPTER 9 Economic Growth II
See p.265 for a nice, brief summary of the story of the Luddites.
CHAPTER SUMMARY
1. Key results from Solow model with tech progress:
Steady-state growth rate of income per person depends solely on the exogenous rate of tech progress
The U.S. has much less capital than the Golden Rule steady state
2. Ways to increase the saving rate
Increase public saving (reduce budget deficit)
Tax incentives for private saving
CHAPTER 9 Economic Growth II
CHAPTER SUMMARY
3. Empirical studies
Solow model explains balanced growth, conditional convergence.
Cross-country variation in living standards is
due to differences in cap. accumulation and in production efficiency.
4. Endogenous growth theory: Models that
examine the determinants of the rate of
tech. progress, which Solow takes as given.
explain decisions that determine the creation of knowledge through R&D.
CHAPTER 9 Economic Growth II
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