8 - Long Run Economic Growth

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1
Fundamental of Economic Growth
L
o
n
g

R
u
n

Why Output Grow in Log run????
DoYouHelptheEconomyMore
ifYouSpend orifYouSave?
Economics in Your Life
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2
TheFactsofGrowth
TheWorldEconomy
TotalGDP(2012):$83T
Population(2012):7B
GDPperCapita(2012):$12,500
PopulationGrowth(2012):1.1%
GDPGrowth(2012):3.3%
GDPpercapitaisprobablythebestmeasureofacountrys
overallwellbeing
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Region GDP % of
World
GDP
GDP Per
Capita
Real GDP
Growth
United States $15T 18% $48,000 1.3%
European Union $16T 19% $33,000 1.0%
J apan $4.3T 6% $34,200 -0.4%
China $7.8T 11% $6,000 9.8%
India $3.2T 5% $2,800 5.6%
Ethiopia $66.3B .09% $800 8.5%
Note.However,thatgrowthratesvarysignificantlyacrosscountries/regions.Doyousee
apatternhere?
Source:CIAWorldFactbook
TheWorldEconomy201213
Atthecurrenttrends,thestandardoflivinginChinawillsurpassthatoftheUSin
25years!Or,willthey?
P
e
r
C
a
p
i
t
a
I
n
c
o
m
e
Thatis,canChinamaintainitscurrentgrowthrate?
TheWorldEconomy
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4
Income GDP/Capita GDP Growth
Low $510 6.3%
Middle $2,190 7.0%
High $32,040 3.2%
Asageneralrule,lowincome(developing)countriestendtohavehigher
averageratesofgrowththandohighincomecountries
Theimplicationhereisthateventually,poorercountriesshouldeventually
catchuptowealthiercountriesintermsofpercapitaincome aconcept
knownasconvergence
TheWorldEconomy
Somecountries,however,dontfitthenormalpatternofdevelopment
Sudan
GDP:$80B(#80)
GDPPerCapita:$2,400(#184)
GDPGrowth:11.2%(#219)
Qatar
GDP:$150B(#59)
GDPPerCapita:$179,000(#1)
GDPGrowth:16.3%(#1)
So,whatisSudandoingwrong?(Or,whatisQatardoingright?)
Atcurrenttrends,PercapitaincomeinQatarwillquadrupleto$716,000
overthenextdecade.Overthesametimeperiod,percapitaGDPin
Sudanwilldropbyroughly40%to$670!!!
TheWorldEconomy
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9 of 26
Growth and Happiness
Happiness and Income per Person across Countries
Developed Country
Lessdeveloped Country
Economists take
for granted that
higher output
per capita
means higher
utility and
increased
happiness.
The evidence
on direct
measures of
happiness,
however, points
to a more
complex picture.
RealGDPLevelVsGrowthRate i.e.GDPatFC(constantprice)baseyear(19992000)
0
500000
1000000
1500000
2000000
2500000
3000000
3500000
4000000
1
9
5
1
-
5
2
1
9
5
4
-
5
5
1
9
5
7
-
5
8
1
9
6
0
-
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1
1
9
6
3
-
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1
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-
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0
0
2
-
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3
2
0
0
5
-
0
6
2
0
0
8
-
0
9
GDPFC at Constant Price (Real GDP)
-6.00
-4.00
-2.00
0.00
2.00
4.00
6.00
8.00
10.00
12.00
1
9
5
1
-
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2
1
9
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4
-
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5
1
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-
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0
-
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9
Trend Line Or Potential Growth
I ndi as Ec onomi c Gr ow t h
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6
Factors Affecting Indias Economic Growth
1. Interest Rates
2. Inflation
3. Currency Strength
4. Tax Levels
5. Govt. Intervention in Industries
6. Environmental Impact
7. Overall Economic Health
8. Natural Calamities
9. Monsoon
10. Business Cycles
11. Other Factors:
Population Growth (N), Human Capital, Natural Resources, FDI, Infrastructure,
Political structure, legal determinants, and Geoography in economic growth
3 sector
1. Agriculture : major source of livelihood and Employment generation
2. Industry : Mixed system
3. Service Sector : Recently growing
Nehru- Mahalanobis Model of Growth
Mahalanobis model is a model of economic development, created by
Indian statistician Prasanta Chandra Mahalanobis in 1953.
It is essentially a developmental planning model and not an economic
growth model of the Harrod-Domar or Solow model variety
Largely follow Soviet Union growth strategy.
Centrally plan structure of growth. Adopted different 5 yr plan for
growth.
The issue of allocation of capital was to be solved in a manner that
economic growth rate could be enhanced.
Agricultural growth was given importance in 1
st
5 yr Plan.
Higher investment in heavy industries could boost the economic growth
( 2
nd
5 yr plan).
Allocating a larger share of Govt. investment in the capital goods sector
and a lower share of investment to the consumption goods sector.
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GDP Growth
Long Run Economic Growth
What determines growth in Log run?
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8
1.4 Economic Growth: A Primer
Questions:
What determines growth?
What is the role of capital accumulation?
What is the role of technological progress?
What is the role of Population Growth
To analyze this, we use the framework of analysis
developed by Robert Solow, from MIT, in the late 1950s.
1. PF in aggregate terms: Y = F (K, N)
2. PF assume constant returns to scale:
xY = F (xK, xN ) for any x > 0
3. Per Worker Production Function
Define: y = Y/N = output per worker
k = K/N = capital per worker
Let x = 1/N. Then Y/N = F (K/N, N/N)
=> y = F (k, 1) or y = f(k)
where f(k) = F(k, 1)
The Production Function
.(1)
.(2)
.(3)
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4: The Production Function F(K,L) satisfies the Inada Conditions
0 ) , ( lim and ) , ( lim
0
= =

L K F L K F
K K K K
0 ) , ( lim and ) , ( lim
0
= =

L K F L K F
L L L L
Note: As f (k)=F
K
have that
0 ) ( ' lim and ) ( ' lim
0
= =

k f k f
k k
Production Functions satisfying 1,2, 3 and 4 often called Neo-Classical
Production Functions
Inada conditions (named after Ken-Ichi Inada) are assumptions about the shape of a production function
that guarantee the stability of an economic growth path in a neo classical growth model.
..(4)
Y
K
) , , ( N K A F
As the capital stock
increases (given a fixed
level of employment), the
productivity of capital
declines!!
K
Y
MP
K
A
A
=
Change in Capital Stock
Change in Production
An economy cant grow through capital accumulation alone forever!
AKN Y =
K A
Y A
K A
Y A
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Per worker Production Function :(Output per worker and Capital per worker)
Increases in capital
per worker lead to
smaller and smaller
increases in output
per worker.
Y
N
F
K
N
N
N
F
K
N
=
|
\
|
.
| =
|
\
|
.
| , ,1
With Constant returns to scale:
The per worker and per capita PF will be
xY F xK xN = ( , )
=> y = f(k) .(3)
The Sources of Growth
1. Savings and Capital Accumulation: (K)
Increases in output per worker (Y/N) can come from
increases in capital per worker (K/N). Higher capital leads to
higher output.
2. Technological Progress (A):
Improvements in the state of technology, shift the
production function, F, and lead to more output per
worker given capital per worker.
3. Population Growth (N):
4. Other Factors:
Human Capital, Natural Resources, FDI, Infrastructure,
Political structure, legal determinants, and geography in
economic growth
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A. Savings, Capital Accumulation
and Output Growth
The effects of the saving rate - the ratio of saving to GDP
on capital and output per capita.
4.1.InteractionsbetweenOutput(Y)andCapital(K)
TheRelationofCapital,Output,SavingsandCapitalAccumulation
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Under CRS, the relation between Y and K per worker is as follows:
Two Assumption we make
The size of the population, the participation rate, and the
unemployment rate are all constant.
There is no technological progress
Under this assumption,
(i) First Relationship is bt Y
t
and K
t
is
, 1
Y K
F
N N
| |
=
|
\ .
a. The Effects of Capital (K
t
) on Output(Y
t
)
4.1. Interactions between Output (Y) and Capital(K)
Y
N
f
K
N
t t
=
|
\
|
.
|
Or y
t
= f(k
t
)
from eq (3)
.(5)
.(6)
Three assumptions to derive the relation between output and investment:
(a) the economy is closed. Y=C+I+G =>
(b) public saving and T G, is equal to zero, means G=0,T=0 and NX=0
( c) private saving is proportional to income,
since
Combining these two relations gives:
where, i=I/N, i.e. investment per worker
I S T G = + ( )
I sY
t t
=
S sY =
I S =
(i)OutputandInvestment
4.1.InteractionsbetweenOutput(Y)andCapital(K)
b.TheEffectsofOutput(Y
t
)onCapitalAccumulation(K
t+1
)
i.Therelationbetweenoutputandinvestment.
IiTherelationbetweeninvestmentandcapitalaccumulation
(ii) TheSecondRelationshipisbtY
t
andK
t+1
is
Ori
t
=sy
t
=sf(k
t
)
(7)
.(8)
(9)
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Capital stock is affected by (a) investment, (b) depreciation.
So, the evolution of the capital stock is given by:
o =denotes the rate of depreciation
= the fractions of the capital stock that wears out each period
I sY
t t
=
K K I
t t t +
= +
1
1 ( ) o
K
N
K
N
s
Y
N
t t t +
= +
1
1 ( ) o
(ii) Investment and Capital Accumulation
b. The Effects of Output(Y
t
) on Capital Accumulation (K
t+1
)
We know that,
So the above equation can be expressed as relationship from output to
capital accumulation
.(10)
.(11)
Assume rate of depreciation () is constant
Rearranging the eqn (11) we can articulate the change in
capital per worker over time:
In other words, the change in the capital stock per worker (left side) is
equal to saving per worker minus depreciation (right side).
K
N
K
N
s
Y
N
t t t +
= +
1
1 ( ) o
K
N
K
N
s
Y
N
K
N
t t t t +
=
1
o
Output and Capital per Worker:
b. The Effects of Output(Y
t
) on Capital Accumulation (K
t+1
)
(ii) Investment and Capital Accumulation
.(11)
.(12)
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Depreciation
Depreciation per
worker, ok
Capital per
worker, k
ok
o = the rate of depreciation o = the rate of depreciation
1
o
Assume rate of depreciation () is constant
Our two main relations are (Summary):
Combining the two relations, we can study the behavior of output and capital
over time.
Y
N
f
K
N
t t
=
|
\
|
.
|
K
N
K
N
s
Y
N
K
N
t t t t +
=
1
o
4-2 Savings, Capital Accumulation and Growth:
The Implications of Alternative Saving Rates
1. First relation Capital determines Output (eqn 5):
2.Second relation Output determines Capital accumulation (eqn 12):
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Dynamics of Capital Accumulation and Output
Substituting first relation into second, (eqn 5 into eqn 12)we get
N
K
N
K
sf
N
K
N
K
t t t t
o
|
.
|
\
|
=
+1
Inferences
If i
t
>k
t
, then k
t
>0
If i
t
<k
t
, then k
t
<0
It means Ak
t
= i
t
ok
t
Since i
t
= sf(k
t
) , this becomes: s f(k
t
) ok
t
Depreciation
during year t
Investment
during year t
Change in capital
from year t to year t + 1
The basic idea: Investment increases the capital
stock, depreciation reduces it.
.(13)
.(14)
.(15)
At K
0
/N, capital per worker is low, investment exceeds depreciation, thus,
capital per worker and output per worker tend to increase over time.
AD = Depreciation
AC = Investment
per worker
CD = k
AB = Output per worker
If i
t
>k
t
, then k
t
>0
If i
t
<k
t
, then k
t
<0
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At K*/N, output per worker and capital per worker remain constant at their long-run
equilibrium levels.
s f(k
t
) = ok
t
When capital and output
are low, investment
exceeds depreciation,
and capital increases.
When capital and output
are high, investment is
less than depreciation,
and capital decreases.
Steady-State Capital and Output
Ak
t
= sf(k
t
) ok
t
Steady State means a Variables of interest grow at
constant rate (balanced growth path or BGP)
If investment is just enough to cover depreciation i.e. sf(k
t
) = ok
t
,
then capital per worker will remain constant: Ak
t
= 0. This occurs
at one value of k, denoted k
*
, called the steady state capital stock.
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Investment
and
depreciation
Capital per
worker, k
sf(k
t
)
ok
t
k
*
Steady-State Capital and Output
Ak
t
= sf(k
t
) ok
t
k
*
,iscalledthesteadystatecapitalstock.
A Numerical Example
Production function (aggregate): Cobb-Douglas Type of PF
= = =
1/ 2 1/ 2
( , ) Y F K L K L K L
| |
= =
|
\ .
1 / 2
1 / 2 1 / 2
Y K L K
L L L
= =
1/ 2
( ) y f k k
To derive the per-worker production function, divide through by L:
Then substitute y = Y/L and k = K/L to get
Let Assume: s = 0.3; o = 0.1 and initial value of k = 4.0
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Exercise: Solve for the steady state
Continue to assume: s = 0.3, o = 0.1, and y = k
Use the equation of motion: Ak = s f(k) ok

to solve for the steady-state values of k, y, and c.
def. of steady state k = 0 A
a n d y k = = * * 3
eq'n of motion with s f k k k o = = ( *) * 0 A
using assumed values k k = 0.3 * 0.1 *
Finally, c s y = = = * (1 ) * 0.7 3 2.1
=>
=>
=>
So solve to get :
With
=>
So, with s=0.3, k*=9, y*=3 and c*=2.1
Approaching the steady state:
A numerical example
Year k y c i k k
1 4.000 2.000 1.400 0.600 0.400 0.200
2 4.200 2.049 1.435 0.615 0.420 0.195
3 4.395 2.096 1.467 0.629 0.440 0.189
Assumptions: ; 0.3; 0.1; initial 4.0 y k s k o = = = =
4 4.584 2.141 1.499 0.642 0.458 0.184
10 5.602 2.367 1.657 0.710 0.560 0.150
25 7.351 2.706 1.894 0.812 0.732 0.080
100 8.962 2.994 2.096 0.898 0.896 0.002
9.000 3.000 2.100 0.900 0.900 0.000

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37 of39
Application:CapitalAccumulationandGrowthin
FranceintheAftermathofWorldWarII
Table 1 Proportion of the French Capital Stock Destroyed by the End of
World War II
Railways Tracks 6% Rivers Waterways 86%
Stations 38% Canal Locks 11%
Engines 21% Barges 80%
Hardware 60% Buildings (numbers)
Roads Cars 31% Dwellings 1,229,000
Trucks 40% Industrial 246,000
WhenWWIIendedin1945,Francehadsufferedsomeofthe
heaviestlossesofallEuropeancountries.Avividpictureofthe
destructionofcapitalisprovidedbythenumbersinTable1.
Policies to Promote Growth
1. Are we saving enough? Too much or too little?
2. What policies may change the savings rate?
3. How should we allocate savings between physical
and human capital?
4. What policies could generate faster technological
progress?
12/5/2013
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Question.
Does savings rate affect the growth rate of output per worker?
Three Possible observations are:
1. The saving rate has no effect on the long run growth rate of output per
worker, which is equal to zero.
2. Nonetheless, the saving rate determines the level of output per worker in
the long run. Other things equal, countries with a higher saving rate will
achieve higher output per worker in the long run.
3. An increase in the saving rate will lead to higher growth of output per
worker for some time, but not forever.
4-3 Different Saving Rates and Growth
The Saving Rate and Output
Solow model predicts
that a country with a
higher saving rate
achieves a higher
steady- state level of
output per worker in
the long run.
The Effects of Different
Saving Rates
An increase in the saving rate raises investment causing k to grow toward a
new steady state.
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An increase in the
saving rate leads
to a period of
higher growth
until output
reaches its new,
higher steady-state
level.
The Effects of an
Increase in the Saving
Rate on Output per
Worker
An increase in the
saving rate leads to
a period of higher
growth until output
reaches a new,
higher path.
The Effects of an Increase in
the Saving Rate on Output per
Worker in an Economy with
Technological Progress
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SocialSecurity,Saving,andCapitalAccumulationin
theUnitedStates
Onewaytorunasocialsecuritysystemisthefullyfunded
system,whereworkersaretaxed,theircontributionsinvested
infinancialassets,andwhenworkersretire,theyreceivethe
principalplustheinterestpaymentsontheirinvestments.
Anotherwaytorunasocialsecuritysystemisthepayasyou
gosystem,wherethetaxesthatworkerspayarethebenefits
thatcurrentretireesreceive.
Inanticipationofdemographicchanges,theSocialSecuritytax
ratehasseenincreases,andcontributionsarenowlargerthan
benefits,leadingtotheaccumulationofaSocialSecuritytrust
fund.
4-4.4.The Golden Rule: Savings and Growth
Different values of s lead to different steady states.
How do we know which is the best steady state?
Definition: Golden Rule,, it is the saving rate that maximises
consumption in the steady-state.
Max. c* = (1s) f(k*).
An increase in s
leads to higher k* and y*, which raises c*
reduces consumptions share of income (1s), which lowers c*.
So, how do we find the s and k* that maximize c*?
12/5/2013
23
The Golden Rule capital stock
the Golden Rule level of capital,
the steady state value of k
that maximizes consumption.
*
gold
k =
To find it, first express c
*
in terms of k
*
:
c
*
= y
*
i
*
= f (k
*
) i
*
= f (k
*
) ok
*
In the steady state:
i
*
= ok
*
because
Ak = 0.
4-4.4.The Golden Rule: Savings and Growth
As C=Y-S
Or C=Y-I
.(16)
Then, graph
f(k
*
) and ok
*
,
look for the
point where
the gap between
them is biggest.
Then, graph
f(k
*
) and ok
*
,
look for the
point where
the gap between
them is biggest.
steady state
output and
depreciation
steady-state
capital per
worker, k
*
f(k
*
)
ok
*
*
gold
k
*
gold
c
* *
gold gold
i k o =
* *
( )
gold gold
y f k =
4.4.TheGoldenRule:SavingsandGrowth
12/5/2013
24
c
*
= f(k
*
) ok
*
is biggest where
the slope of the
production
function equals
the slope of the
depreciation line:
c
*
= f(k
*
) ok
*
is biggest where
the slope of the
production
function equals
the slope of the
depreciation line:
steady-state
capital per
worker, k
*
f(k
*
)
ok
*
*
gold
k
*
gold
c
MPK =o
AchievingtheGoldenRulerequiresthat
policymakersadjusts.
Table
The Saving Rate and the Steady-state Levels of
Capital, Output, and Consumption per Worker
Saving Rate, s
Capital per
Worker, (K/N)
Output per
Worker, (Y/N)
Consumption per
Worker, (C/N)
0.0 0.0 0.0 0.0
0.1 1.0 1.0 0.9
0.2 4.0 2.0 1.6
0.3 9.0 3.0 2.1
0.4 16.0 4.0 2.4
0.5 25.0 5.0 2.5
0.6 36.0 6.0 2.4

1.0 100.0 10.0 0.0
The U.S. Saving Rate and the Golden Rule
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25
The set of skills of the workers in the economy is called
human capital.
An economy with many highly skilled workers is likely to be
much more productive than an economy in which most
workers cannot read or write.
The conclusions drawn about physical capital accumulation
remain valid after the introduction of human capital in the
analysis.
4.5 Physi c al ver sus Human Capi t al
ExtendingtheProductionFunction
Whenthelevelofoutputperworkersdependsonboththelevelofphysicalcapitalper
worker,K/N,andthelevelofhumancapitalperworker,H/N,theproductionfunctionmaybe
writtenas:
Y
N
f
K
N
H
N
=
|
\
|
.
| ,
( , ) + +
Anincreaseincapitalperworkerortheaverageskillofworkersleadstoanincreaseinoutput
perworker.
ExtendingtheProductionFunction
4.5 Physi c al ver sus Human Capi t al
Ex.Supposeaneconomyhas100workers,halfofthemunskilledandhalfofthemskilled.
Therelativewageofskilledworkersistwicethatofunskilledworkers.
Then:
H
H
N
= + = = = [( ) ( )] . 50 1 50 2 150
150
100
15
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26
B. Tec hnol ogi c al Pr ogr ess and Gr ow t h
Technology istheuseofscientificknowledgefor
improvingthewaytodothings.
GiventheamountofCapital(K)andLabor(L)
Technologicalprogressleadsto
Increaseoutput
Betterproducts
Newproducts
Alargervarietyofproducts
5.1TechnologicalProgressandtheRateofGrowth
12/5/2013
27
TheProductionFunction
Y F K N A = ( , , )
(+ + +)
Y F K AN = ( , )
ThePFwillbe:
Amorerestrictivebutmoreconvenientformis
ANislaboraugmentingtechnology
Dividingboththesideofeq18byAN,weget
Redefineeq(19)
.(17)
.(18)
, 1
Y K
F
AN AN
| |
=
|
\ .
.(19)
Y K
f
A N A N
| |
=
|
\ .
.(20)
Inwords:Outputpereffectiveworker isafunctionofcapitalpereffectiveworker.
Because of Decreasing
Returns of Capital (K),
K/AN=>Y/AN.
OutputperEffective
WorkerversusCapital
perEffectiveWorker
TheProductionFunction
12/5/2013
28
1. The Relation between output per worker and capital per worker.
I S sY = =
I
AN
s
Y
AN
=
|
\
|
.
|
Dividing both sides by AN, we get
Interactions between Output and Capital
2. The Relation between investment per worker and capital per worker.
Given that
Y
AN
f
K
AN
=
|
\
|
.
|
I
AN
sf
K
AN
=
|
\
|
.
|
then,
3. The Relation between depreciation per workerequivalently, the investment per
worker needed to maintain a constant level of capital per workerand capital per
worker.
oK g g K
A N
+ = ( )
( ) o + + g g K
A N or
( ) o + + g g
K
AN
A N
The amount of investment per effective worker needed to maintain a constant level
of capital per effective worker is
5.1 Technological Progress and the Rate of Growth
1. Capital per effective worker and
output per effective worker
converge to constant values in the
long run.
2. Output per effective worker
increases with capital per effective
worker, but at a decreasing rate.
3. The relation between investment
per effective worker and capital
per effective worker is drawn as
the upper curve, multiplied by the
saving rate, s.
4. Finally, now that we allow for
technological progress (so A
increases over time), the number
of effective workers (AN) increases
over time.
TheDynamicsofCapitalper
EffectiveWorkerandOutput
perEffectiveWorker
InteractionsbetweenOutputandCapital
12/5/2013
29
In steady state, output (Y) grows at the same rate as effective
labor (AN); effective labor grows at a rate (g
A
+g
N
); therefore,
output growth in steady state equals (g
A
+g
N
). Capital per
effective worker also grows at a rate equal to (g
A
+g
N
).
The growth rate of output is independent of the saving rate.
Because output, capital, and effective labor all grow at the
same rate, (g
A
+g
N
), the steady state of the economy is also
called a state of balanced growth.
InteractionsbetweenOutputandCapital
Technologicalprogressinmoderneconomiesistheresultoffirms
researchanddevelopment(R&D) activities.TheoutcomeofR&Dis
fundamentallyideas.
SpendingonR&Ddependson:
1.Thefertility oftheresearchprocess,orhowspendingonR&D
translatesintonewideasandnewproducts, dependsupon
interactionbetweenbasicresearchandappliedresearch
and
2.theappropriabilityofresearch results,ortheextenttowhichfirms
benefitfromtheresultsoftheirownR&D,whichdependsupon
dependsuponlegalprotectionsuchaspatents.
52TheDeterminantsofTechnologicalProgress
12/5/2013
30
ThankYouAll

8 - Long Run Economic Growth

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12/5/2013

Use the equation of motion: Ak = s f(k) ok

10 5.602 2.367 1.657 0.710 0.560 0.150

25 7.351 2.706 1.894 0.812 0.732 0.080

100 8.962 2.994 2.096 0.898 0.896 0.002

9.000 3.000 2.100 0.900 0.900 0.000

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