Economic Growth

•Economic growth and development•Why are national growth rates so similar?•Why do some countries experience spectacular levels of growth?•What are the determinants of growth?

Economic Growth and Development 1/2We were concerned with growth last week but how do we define and

measure development?• The Human Development Index (HDI) is a summary measure of human

development that is published by the United Nations Development Programme (UNDP). The HDI provides an alternative to the common practice of evaluating a country’s progress in development based on per capita Gross Domestic Product (GDP)

• HDI = 1/3 (life expectancy index) + 1/3 (education index)+ 1/3 (GDP index) – A long and healthy life, as measured by life expectancy at birth. – Knowledge, as measured by the adult literacy rate (with two-thirds weight) and the

combined primary, secondary and tertiary gross enrollment ratio (with one-third weight). – A decent standard of living, as measured by GDP per capita in purchasing power parity

(PPP) terms in US dollars.

• The HDI has had a significant impact on drawing the attention of governments, corporations and -international organizations to aspects of development that focus on the expansion of choices and freedoms, not just income

Economic Growth and Development 2/2

• Is there, empirically, any fixed correspondence between growth and development?

see appendix 2.1: look for examples with – high p.c.GDP/low development – high development/low p.c.GDP

Why are national growth rates so similar?Why do some countries experience spectacular levels of growth? 1/3

Growth rates across the world 65-95:• “spectacular”: China (8.2% 80-95)• “very good”: East Asia (5.5% 65-90)• “decent”: South East Asia• “bad”: Latin America• “very bad”: Sub-Saharan Africa

Why are national growth rates so similar?Why do some countries experience spectacular levels of growth? 2/3

Making sense of growth figures:• small numbers go a long way: the number of

years necessary to double income is equal to 70/growth rate– if the economy is growing at 5% per year, it will

take 14 years to double in size– if the economy is growing at 1% per year, it will

take 70 years to double in size

Why are national growth rates so similar?Why do some countries experience spectacular levels of growth? 3/3

Growth of GDP per capita (average annual percentage changes)

1500-1820 1820-1900 1900-2000

OECD 1.2 2.0

Non-OECD 0.4 0.6

World 0.04 0.8 1.9

Source: Boltho and Toniolo (1999, Table 1) OECD refers to North America, Western Europe, Japan, Australia and New Zealand.

USA, UK and EIRE5

000

150

002

5000

350

00R

eal G

DP

pe

r ca

pita

(P

WT

6.1,

ch

ain)

1965 1970 1975 1980 1985 1990 1995 2000year

GBR IRLUSA

Growth of GDP p.c: USA=2.2%, GBR=2.0%, Ireland=3.7% (but post-93, 8.5%)GDP per capita is US$ 1996 constant prices.

China and India0

100

02

000

300

04

000

Rea

l GD

P p

er

capi

ta (

PW

T6.

1, c

hai

n)

1965 1970 1975 1980 1985 1990 1995 2000year

CHN IND

Growth: pre-90 China 3.7%, India 4.4%. 1990-2000: China 7.0%, India 4.4%

Brazil, S. Korea, Philippines0

500

01

0000

150

00R

eal G

DP

pe

r ca

pita

(P

WT

6.1,

ch

ain)

1965 1970 1975 1980 1985 1990 1995 2000year

BRA KORPHL

Economic growth determinants: stylised facts

1.Output per capital and capital intensity keep increasing Labour (L) measured in man-hours grows more slowly than capital (K) and output (Y)This means that (K/L)↑ and (Y/L)↑Capital

2. Output ratio is trendless3. Hourly wages keep increasing 4. The rate of profit is trendless5. The relative share of GDP going to L and K is

trendless

Growth Determinants (1)

Savings and Investment: from the circular flow we see household and firms save part of their income. Savings flow in the financial system and channelled to borrowers (firms and households)

Questions: does more savings necessarily means more growth?

Aggregate production function Y=f(K,L)

• Goods and services are produced using two factors of production. A production function is commonly used in microeconomics to describe how firms combine K and L. In this case, this is used to described the output production of the entire economy.

How do we finance investment?

• Remember that (S-I)+(T-G)=(X-Z)So investment can be financed

by private savings by firms and households (S)by government savings by net savings of foreigners

I=S+(T-G)+(Z-X)

• We assume that T=G →the government does not run a deficit

• We also assume Z=X → current account balance

Then I=S Investment is financed by domestic savings

• However, old capital depreciates, the proportion of capital that is lost is called depreciation rate and usually indicated with δ

• Definition of steady state

Neoclassical growth model • Model growth of GDP per worker via capital accumulation• Key elements:

– Production function (GDP depends on technology, labour and physical capital)

– Capital accumulation equation (change in net capital stock equals gross investment [=savings] less depreciation).

Solow-Swan assume: a) diminishing returns to capital or labour (the ‘law’ of diminishing returns), and b) constant returns to scale (e.g. doubling K and L, doubles Y).For example, the Cobb-Douglas production function

• Questions:– how does capital accumulation (net investment) affect growth?– what is role of savings, depreciation and population growth?– what is role of technology?

GDP per worker and kAssume A and L constant (no technology growth or

labour force growth)

y=Af(k)=Aka

k(capital per worker)

y

outp

ut p

er w

orke

r

concave slope reflects diminishing marginal

product of capitaldY/dK=dy/dk=aAka-1

Graphical analysis of

k (capital per worker)

y

outp

ut p

er w

orke

r

sy

dk

k*

net investment(savings = gross

investment)

(depreciation)

(Note: s and d constants)

dksy k

dtd

Solow-Swan equilibrium

k

you

tput

per

wor

ker

sy

dk

k*

y*

y=Aka

consumptionper worker

GDP p.w. converges to y* =A(k*)a. If A (technology) and L constant, y* is also constant: no long run growth.

What happens if savings increased?• raising saving increases k* and y*, but long run

growth still zero (e.g. s1>s0 below)• call this a “levels effect”• growth increases in short run (as economy moves to

new steady state), but no permanent ‘growth effect’.y

s0y

dk

k0*

y1*y=Aka

s1y

k1*

y0*

What if labour force grows?Accumulation eqn now ( ) where / (math note 2)

dk dLsy n k n L

dt dtd

k

y

ou

tpu

t p

er

wo

rke

r

sy(dn)k

kn*

dk

y

Population growth (n>0) pivots the ‘depreciation’ line upwards, and reduces k and y steady state

Population growth reduces equilibrium level of GDP per worker (but long run growth still zero) if technology static

Analysis in growth ratesCan illustrate above with graph of gk and k

kcapital per worker

Dis

tan

ce b

etw

ee

n li

ne

s is

g

row

th r

ate

of

cap

ital p

er

wo

rke

r

dn

k*

net investment

net disinvestment

average product of capitalys sk

Distance between lines represents growth in capital per worker (gk)

( ) ( )k

dkdk ydtsy n k g s ndt k k

d d

Rise in savings rate

(s0 to s1)

NB: This graph of how growth rates change over time

gY, gk

TimeSaving change

0 %

1

ysk

gY=(MPK/APK) gk = sk gk

(sk = a in Cobb-Douglas case)

gk

dn

k*

0

ysk 1

ysk

A

B

C

k

Solow’s surprise*• Solow’s model states that investment in capital cannot

drive long run growth in GDP per worker• Need technological change (growth in A) to avoid

diminishing returns to capital • Easterly (2001) argues that “capital fundamentalism”

view widely held in World Bank/IMF from 60s to 90s, despite lessons of Solow model

• Policy lesson: don’t advise poor countries to invest without due regard for technology and incentives

* This is title of Chapter 3 in Easterly (2001), which is worth a quick read for controversy surrounding growth models and development issues

What if technology (A) grows?• Consider y=Aka, and sy=sAka, these imply that

output can go on increasing.• Consider marginal product of capital (MPk)

MPk=dy/dk =aAk -1a ,

if A increases then MPk can keep increasing (no ‘diminishing returns’ to capital)

• implies positive long run growth

…. graphically, the production function simply shifts up

k

y

outp

ut p

er w

orke

r

dk

y=A0ka

y=A1ka

y=A2ka

Technology growth:A2 > A1 > A0

Capital to labour ratio

0

1

2

Golden rule• The ‘golden rule’ is the ‘optimal’ saving rate (sG)

that maximises consumption per head.• Assume A is constant, but population growth is n.• Can show that this occurs where the marginal

product of capital equals ( + d n)

Graphically find the maximal distance between two lines

k

y

ou

tpu

t p

er

wo

rke

r

(nd)k

k**

y**maximal

consumptionper worker

slope=dy/dk=n+d

capital per worker

y

sgold y

… over saving

Economies can over save. Higher saving does increase GDP per worker, but real objective is consumption per worker.

k

y

outp

ut p

er w

orke

r

sgoldy(nd)k

k**

y**

y=Aka

maximalconsumptionper worker

sovery

slope=dy/dk=n+d

k*capital per worker

Role of Savings empirical 1

• What we said so far is that the more a country saves, the more it invests; the more it invests, the higher its capital-output ratio; the higher its capital-output ratio, the higher its output-labour ratio.

• Output-labour ratio is p.c. Income, hence countries with high savings and investment should show high p.c. Income. Is this true?

Role of savings empirical2

Solow’s surprise: more than savings

• This model most often attributed to Robert Solow (1956) – US Nobel prize winner …. but Trevor Swan (1956) (a less well known Australian economist) published (independently) a very similar paper in the same year – hence refer to Solow-Swan model

Summary of Solow-Swan• Solow-Swan, or neoclassical, growth model, implies

countries converge to steady state GDP per worker (if no growth in technology)

• if countries have same steady states, poorer countries grow faster and ‘converge’ – call this classical convergence or ‘convergence to steady

state in Solow model’• changes in savings ratio causes “level effect”, but

no long run growth effect• higher labour force growth, ceteris paribus, implies

lower GDP per worker

Limitations of Solow’s model

• Technological progress is exogenous, it falls as manna from Heaven” (thus also called exogenous growth model)– How can technological progress be facilitated?– Is technological growth and hence economic growth

sustainable?• The model is too optimistic in forecasting

convergence among countries• The model does not explain lack of growth until

1800

•

Limitations of Solow model (cont.)- The model cannot explain the empirical significant relation between saving rates and technological progress

Endogenous (or “new”) growth models

• Explain where technological change comes from• How it can be influenced by behavioural variables• Under what conditions growth may continue

Assumptions• exogenous shock do not occur• Expectations are correct• Prices and quantities are fully adjusted by perfect competition in final

goods and labour markets• Monopoly rents for new ideas are possible assumed to be fully protected • Labour, capital and technology are the production factors• All new ides are used • Existing technology promotes production of new ideas (standing on

shoulder effect)

Flow chart of a Romer Economy

Limits endogenous growth models

• Powerful assumptions• Un-realistic developments• Can ideas be owned? Any empirical

considerations?

Questions for discussionTo read http://www.economist.com/node/6943519?story_id=6943519

1. Explain the effect of (i) an increase in savings ratio (ii) a rise in population growth and (iii) an increase in exogenous technology growth in the neoclassical model. Provide some empirical evidence using appendix 2.2

2. What is the golden rule? Can you think of any country that has broken the golden rule? Provide some evidence from appendix 2.3

3. How can we discuss data in appendix 2.4 from the endogenous growth theory perspective?

References

• Boltho and Toniolo (1999, Table 1)• United Nations: Human Development index

http://hdr.undp.org/en/humandev/• Sloman Eocnomics