Overview of Course

Households Government

Y = C + I + G + NX

Firms Foreign Sector

 Overview of Course
Households
Labor Market

F(A,K,N) = Y = C + I + G + NX

Labor Market

Capital Market Capital Market

Firms

Topic II: The Supply Side

 Overview of Course
Households

Consumption/Savings

F(A,K,N) = Y = C + I + G + NX

Investment Demand

Firms

Topic III: The Demand Side: Consumption and Savings

 Overview of Course
Households Government

Consumption/Savings

F(A,K,N) = Y = C + I + G + NX

Investment Demand

Firms

Topic IV: The Demand Side: Fiscal Policy

 Overview of Course
Households Government

F(A,K,N) = Y = C + I + G + NX

Firms Foreign Sector

Topic IX: International Economy

 Overview of Course
Households Government

F(A,K,N) = Y = C + I + G + NX

P = Price of Y
i = nominal interest rate

The Fed Firms Foreign Sector

Topic V: Monetary Policy

 Overview of Course
Households Government
W/P

F(A,K,N) = Y = C + I + G + NX

W/P Inflation =
P = Price of Y
i = nominal interest rate

The Fed r i- Firms Foreign Sector

Topic V: Monetary Policy

 Overview of Course
Households Government
W/P

F(A,K,N) = Y = C + I + G + NX

W/P Inflation =
P = Price of Y
i = nominal interest rate

r i-
The Fed Firms Foreign Sector

Topic VI and VII: Policy in Action

 Next Topic
Households
Labor Market

F(A,K,N) = Y = C + I + G + NX

Labor Market

Capital Market Capital Market

Firms

Topic II: The Supply Side (PART 1: LONG RUN ISSUES)

Topic II

The Supply Side (PART 1: LONG RUN ISSUES)

BOOTH

WINTER 2017

MARK L. J. WRIGHT
 US Living Standards
40,000 9/11/2001

First oil
30,000
price shock
long-run upward trend
20,000
Great
Depression Second oil
10,000
price shock

World War II
0
1900 1910 1920 1930 1940 1950 1960 1970 1980 1990 2000
Taiwan vs Argentina
25000

21,000

20000

15000
Taiw an

Argentina 11,000

10000

7,250

5000

975

0
1950 1955 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005
 Relative to USA

0
20
40
60
80
100
120
140
160

Congo, Dem. Rep.

Burundi
Ethiopia
Chad
Cambodia
Zambia
Bangladesh
Sudan
India
Zimbabwe

0 0 0 0 1 1 1 1 1 2 2
Angola
Congo, Rep.
China

3 3 4
Egypt, Arab Rep.
Iran, Islamic Rep.

5 5
Russian
Turkey

9 10
Botswana

11
Brazil
Chile

14 15
World

17
Mexico 22
Argentina
26

Saudi Arabia
2000 US dollars

Greece
30 31

Korea, Rep.
39

New Zealand
42
GDP per Person

Spain
50

Kuwait
53

Israel
56

Italy
60

Australia
France
Singapore
Germany
65 67 67 67

Canada
United Kingdom
Austria
70 70 70

Netherlands
Ireland
73 73

Hong Kong, China

79

Sweden
Switzerland
United States
99 100

Japan
Norway
106107

Luxembourg
134
 Relative to USA

0
20
40
60
80
100
120
140
160

Congo, Dem. Rep.

Burundi
Ethiopia
Chad

2 2 2 2
Cambodia

5
Zambia

2
Bangladesh

4 4
Sudan
India

7 7
Zimbabwe
Angola
Congo, Rep.

4 3
China
Egypt, Arab Rep.

11 10
Iran, Islamic Rep.

17
Russian
Turkey

20 19
Botswana

24
Brazil

21
Chile
World 26
Mexico 22
27

Argentina
35

Saudi Arabia
39

Greece
49

Korea, Rep.
47

New Zealand
59
2000 US dollars at International Prices
GDP per Person

Spain
64

Kuwait
57

Israel
67

Italy
75

Australia
France
79 79

Singapore
68

Germany
75

Canada
79

United Kingdom
77

Austria
82

Netherlands
87

Ireland
84

Hong Kong, China

Sweden
76 77

Switzerland
91

United States
100

Japan
74

Norway
99

Luxembourg
146
 Why growth matters
Anything that effects the long-run rate of economic growth
even by a tiny amount will have huge effects on living standards
in the long run.

annual percentage increase in

growth rate standard of living after
of income
per capita 25 years 50 years 100 years

2.0% 64.0% 169.2% 624.5%

2.5% 85.4% 243.7% 1,081.4%

Income and poverty in the world
selected countries, 2000
I do not see how one can look at figures like these without
seeing them as representing possibilities. Is there some
action a government could take that would lead the Indian
economy to grow like Indonesias or Egypts? If so, what
exactly? If not, what is it about the nature of India that
makes it so? The consequences for human welfare
involved in questions like these are simply staggering:
Once one starts to think about them, it is hard to think
about anything else.

- Robert E. Lucas, Jr. (1988) p.5

Growth and Catch Up
 Ranking these countries from lowest to highest initial
GDP per capita, examine their subsequent growth.
Country % growth rate,
1870-2006
initial
income
Lowest

Japan 2.5%
Sweden 2.0%
Canada 2.0%
Germany 1.8%
France 1.8%
US 1.9%
initial
income
Highest

UK 1.5%
Australia 1.5%
 General findings on growth:
Among industrialized countries, those that were the poorest initially grew
the most quickly

Why might this be the case?

Will this be true of China and India?

If not, why might this not be true across all countries?

20
Will China Overtake USA?
 Will Soviet Union Overtake USA?
Question posed to
Robert Solow as advisor
to Pres. Kennedy by
Secretary of Defense
Robert S. McNamara

Source: http://ripetungi.com/soviet-era-infographics/
 Will Japan Overtake USA?
In 1970, Herman Kahn's
"The Emerging
Japanese Superstate"
predicted that Japan
would surpass the
United States as the
leading economic power
in the world by the year
2000.
 Will Japan Overtake USA?
In 1970, Herman Kahn's
"The Emerging
Japanese Superstate"
predicted that Japan
would surpass the
United States as the
leading economic power
in the world by the year
2000.
Plan for Topic II (PART 1) of Course
Long run issues
Solow-Swan Growth Model
Growth Facts & Growth Implications for Development
Accounting Evaluation of these predictions
Case study: the US productivity Lessons for government?
slowdown of the 1970s
Case Study: an East Asian growth The Golden Rule of Savings
Miracle?
Inequality and Growth
Solow-Swan Growth Model
Analysis of model Next, in PART 2:
Labor markets and unemployment
Comparative statics
Implications for Growth
Growth Facts
Growth Facts: Nicholas Kaldor
In first part of 20th Century, British economist Nicholas Kaldor
discovered the following facts for US and most other industrial
economies:

1. Real GDP (Output) per worker Y/L and capital per worker K/L
grow over time at positive and roughly constant rates
2. They grow at roughly the same rate so that Y/K is constant
3. The real return to capital r (and the real interest rate r - ) is
roughly constant over time
4. The shares of income going to capital and labor are roughly
constant
 Growth Accounting
Where does growth come from?
More inputs (capital and labor)?
Better use of inputs? (improved technology or productivity)

How measure productivity?

As residual!
Measure outputs and inputs, measure effect of increased inputs, and whatever is left is productivity

To determine productivity growth, need a benchmark for effect of input growth

Data gives us the following two estimates:

If capital increases by 10%, output increases by 3%
If labor increases by 10%, output increases by 7%

These are the elasticities that ABC calculate:

The elasticity of output with respect to capital is 0.3 (= 3/10, the ratio of the percentages above)
The elasticity of output with respect to labor is 0.7 (= 7/10, the ratio of the percentages above)
Suppose you observe capital, labor, and output all go up.
How much of the output growth is due to inputs and how
much is productivity?

Expected output growth =

.3 growth(K) + .7 growth(L)

Productivity growth = growth(Y)

[.3 growth(K) + .7 growth(L)]

Productivity growth is the growth in output not explained

by growth in inputs.
29
Productivity growth is the growth in output not explained by
growth in inputs.

Analytically, this is expressed in the growth accounting

equation:

Y N K A
= aN + aK +
Y N K A
Output = Labor + Capital + Productivity
Growth Growth Growth Growth

30
Use this framework to analyze US and
Japanese growth
US Japan
Growth in 1970 1985 Growth 1970 1985 Growth

Real output, Y 2083 3103 2.66% 620 1253 4.69%

Capital, K 8535 13139 2.83% 1287 3967 7.50%

Employment, N 78.6 104.2 1.88% 35.4 45.1 1.61%

Employment is measured in millions of workers, real output and capital in billions of 1980 US
dollars. Growth rates are average annual percentage rates.
Calculating productivity growth:
US Japan
Growth in 1970 1985 Growth 1970 1985 Growth

Real output, Y 2083 3103 2.66% 620 1253 4.69%

Capital, K 8535 13139 2.83% 1287 3967 7.50%

Employment, N 78.6 104.2 1.88% 35.4 45.1 1.61%

Productivity 2.66 .3(2.83) 0.50% 4.69-.3(7.5) - 1.31%

-.7(1.88) = .7(1.61) =
Employment is measured in millions of workers, real output and capital in billions of 1980 US
dollars. Growth rates are average annual percentage rates.
From cross-country to time series:

33
Growth Accounting for Other Countries:
East Asian Miracle?
Country Period gY gK (1-)gL gA

Germany 60-90 3.2 59 % -8 % 49 %

Italy 60-90 4.1 49 % 3% 48 %

UK 60-90 2.5 52 % -4 % 52 %

Argentina 40-80 3.6 43 % 26 % 31 %

Brazil 40-80 6.4 51 % 20 % 29 %

Chile 40-80 3.8 34 % 26 % 40 %

Mexico 40-80 6.3 41 % 23 % 36 %

Japan 60-90 6.8 57 % 14 % 29 %

Hong Kong 66-90 7.3 42 % 28 % 30 %

Singapore 66-90 8.5 73 % 31 % -4 %

South Korea 66-90 10.3 46 % 42 % 12 %

Taiwan 66-90 9.1 40 % 40 % 20 %

East Asian Miracle?
Growth rates in East and South East Asia were very high
Twice as large as in Europe and the United States
Growth accounting shows that this was almost entirely due to
faster capital accumulation, and labor supply growth
Technological progress in these countries was on average much
slower in the rest of the world
Many people conclude that there is nothing special about these
countries: there was no Miracle
But growth rates of capital were very large by historical
standards: isnt this miraculous?
However, growth rates have been lower in 1990s after Asian
Crisis and Japanese slump
The Solow-Swan Model
Solow-Swan Growth Model
Why do poor countries grow faster than rich countries?
Why is productivity growth so crucial for long run growth in living
standards?
Robert Solow and Trevor Swan set out to answer these questions
We will also seek to answer question: will China overtake USA?
Robert McNamara (Secretary of Defense under President Kennedy)
asked Solow a version of this question for the Soviet Union. His answer:
No! Due to logic of Solow-Swan model
 The Most Basic Solow-Swan Model
Basic assumptions and variables:

Population and work force constant

Economy closed to world trade and G = 0
Yt = Ct + It
Production uses physical capital and labor
Yt = F(Kt ,Lt)
Diminishing returns to physical capital

38
Diminishing returns implies output is a bowed out
(concave) function of the capital stock:

F(K,L)

K
Basic Model (continued)
Remaining assumptions of the model:

Economy saves a constant fraction s of the income it generates

All savings are channeled to investment in new physical capital
A constant fraction d of physical capital depreciates at the end of each period

40
Savings are also a concave function of the
capital stock:

S = sY

K
But savings equal investment, so we know
how much investment for each K

I=S

K
Although I units are added to physical
capital, dK is lost to depreciation:

dK

net increase
in
physical
capital
K
K rises when I > dK, falls when I < dK, and
doesnt change when K = Kss

dK

K < Kss K > Kss

K
Kss
Summary of results so far:
Model tells us how economy evolves when technology and
labor force are fixed:
Capital stock will move toward a steady state level Kss
For K < Kss, savings exceeds amount of investment needed to
keep K constant; K rises, output grows
For K > Kss, savings falls below investment needed to keep K
constant, K falls, output shrinks
Growth occurs because of capital accumulation, which
eventually stops because of diminishing returns

45
Extending the Solow-Swan model:
Allow for population to grow at rate n:
Define everything per-worker:
y = Y/L = f(k) = f(K/L)

The per-worker production function has same bowed out shape as before
Investment raises capital per-worker if it
Replaces worn out capital, dk
Keeps up with population growth, nk

i > (n + d)k

46
Model looks identical, but investment must cover
depreciation and population growth

(n+d)k

i=sf(k)

k < kss k > kss

k
Solow-Swan model w/population growth
When labor force is constant, model implies that the
capital stock, consumption, and output are constant
in steady state
With employment growth, steady state involves
constant capital stock, consumption, and output per
worker
At steady state, capital stock, consumption, and
output grow, at same rate as labor force
If production technology, savings rate, and population
growth are all fixed, GDP per worker ultimately stops
growing

48
Insights from Solow-Swan model
1. Convergence
Poorer countries (K < Kss) should grow more than
rich ones (K close to Kss)
Capital accumulation is a major engine of growth in
these poorer countries

49
Solow and Soviet threat
Why would Solow think based on his model
that Soviet Union wouldnt overtake US?
What type of evidence would support this
conclusion?
Why dont countries like Ghana seem poised to
overtake US?

50
Insights from Solow-Swan model
2. What drives growth of GDP per capita?
Need steady state to grow
Steady state: sf(kss) = (n+d)kss, so need change in one of these
The saving rate - s
Population growth - n
Productivity growth - f(k)

51
On the importance of productivity growth
We will show that living standards rise with saving rate
and fall with population growth
Both are limited source of growth: savings rate at most
100%, cant shrink population indefinitely
By contrast, productivity and innovation can be sustained
indefinitely, at least in principle
Upshot: Productivity growth is what ultimately
determines how quickly living standards rise

52
The determinants of GDP per capita
1. The saving rate effect of savings tax credits

(n+d)k

i=s2 f(k)
i=s1 f(k)

k
kss kss
1 2
The determinants of GDP per capita
1. The saving rate

Higher saving rate means higher investment

GDP per capita will grow initially as more capital is
accumulated, but not in long run
Is society always better by raising the savings rate and
raising output per worker?

54
The determinants of long-run living standards
2. Population growth effect of one-child policy

(n1+d)k

(n0+d)k

i=sf(k)

k
kss kss
1 2
The determinants of long-run living standards
2. Population growth
Lower population growth means kss higher, so higher
output per worker in long run and higher growth
during transition
True even though GDP grows more slowly (both
immediately and in steady state)
Is society better off with lower population growth?

56
The determinants of long-run living standards
3. Productivity growth advent of new technology

(n+d)k

i=sf2(k)

i=sf1(k)

k
kss kss
1 2
The determinants of long-run living standards
3. Productivity growth
Productivity improvement raises output per worker for
a given capital-labor ratio
On top of that, it leads to additional capital
accumulation, so higher capital-labor will raise output
per worker even more

58
Recap: Lessons from Solow-Swan
Solow model offers a benchmark of how a countrys GDP should evolve over
time
Emerging countries far from steady state and grow rapidly, poor/rich
countries close to their steady-state and dont
Eventually, growth in GDP per capita requires productivity growth

59
Evaluating Solow-Swan Model
How well do the implications that we derived stack up
against the evidence?

1. Higher savings rate implies, everything else equal, higher

output per capita levels
2. Higher population growth implies, everything else equal,
lower output per capita
3. Everything else equal, the poorer the country the higher
the growth rate (and so economies converge)
4. Higher savings rates have no long run effect on growth
Investment Rate and Output per capita
Population Growth Rates
Convergence
More on Convergence
Graph indicates convergence among rich countries, but not among poor
countries
But everything else equal is an important (and heroic) assumption
If countries differ in terms of n, or s, all will grow at different rates in
steady state, and converge to different steady state levels of k
Whether or not one country grows faster than another will depend
upon its level of n, and how far away they are from their steady state.
What if control for differences in investment rates and population
growth rates (where investment is interpreted broadly to include
investment in people such as education, health care, etc.)?
Looks like there is more evidence in favor of convergence (conditional
convergence)
Savings rates and growth rates
Summary: Lessons for Government?
The Solow-Swan model tells us that the government cannot
affect the long run growth rate of output per capita in an
economy unless it can affect the growth rate of
technological progress
Implications for property rights? Intellectual property rights?
The Solow-Swan model predicts that a government can
increase the level of output per capita if it can
Increase the level of A
Implications for work practices, technology adoption, intellectual property
rights?
Increase the savings rate
Implications for property rights, social security, taxation of savings?
Golden Rule of Savings
Should the government adopt policies to increase the savings rate?
Increasing savings rates does increase output per capita
But it also reduces consumption per capita
If people care about income only to the extent that it allows them to
consume more, what is the optimal savings rate?
The result is called the Golden Rule of Savings
The Golden Rule capital stock
k gold
*
= the Golden Rule level of capital,
the steady state value of k
that maximizes consumption.

To find it, first express c* in terms of k*:

c* = y* sy*
= f (k*) sy*
In the steady state:
= f (k ) (n+) k
* *
sy* = (n+)k*
 The Golden Rule capital stock
steady state (n+) k *
output and
Then, graph depreciation
f(k*) and (n+)k*
f(k * )
and look for the
point where
the gap between c gold
*

them is biggest.
i*gold = (n+) k*gold

k gold
*
steady-state
y gold = f (k gold )
* *
capital per
worker, k *
 The Golden Rule capital stock
(n+) k *
c* = f(k*) (n+) k*
is biggest where the f(k * )
slope of the production
function
equals c gold
*

the slope of the

depreciation line:
MPK = n+ k gold
*
steady-state
capital per
worker, k *
Income Inequality: A First Look
Income Inequality in Development
So far, when talking about levels of development across countries, we have
focused on GDP per person (per capita)
This is an average measure of welfare and ignores the distribution of
income.
Differences in the distribution of income can be significant, e.g.
In 1995 , real GDP per capita was
$4,670 in Paraguay
$2,960 in Egypt
Fraction of people living on less than $1 per day was
19.4% in Paraguay
3.1% in Egypt

Paraguay has one of the most unequal income distributions in the world
Income Inequality in Growth
The Paraguayan example shows that a country can be more
developed on average, yet have a much greater proportion of its
population in poverty
What is the effect of growth on inequality?
Simon Kuznets (Nobel laureate 1971) hypothesized that growth
initially causes inequality to rise, and then fall
Kuznets Hypothesis
If you plot a measure of income inequality over time for a growing country,
you should see a hump shaped relationship

To test if this is true, we need to know: How should we measure

income inequality?
Kuznets Curve
Measuring Income Inequality
One way is to divide the population of a country into different
categories of income, and look at the fraction of the population in
each
For the US, the following graph shows the category is $10K-$15K (6.9%)
Note that income distribution is skewed; it has a long right tail

Another way to measure inequality is to order people by income,

and plot the fraction of all income earned by percentiles (the
bottom 1%, 5%, 10% etc). The top 100% earns all income!
Such a plot is called a Lorenz curve
Income Distribution in USA
Lorenz Curve for USA
 Inequality: Gini Coefficients
The Lorenz curve has a bowed in shape because of inequality
The more bowed, the less equal (more unequal)
The Gini coefficient is a measure of this:
The area between the 45-degree line and the Lorenz curve, divided by the
total area under the 45-degree line, is the Gini coefficient
If income is perfectly evenly distributed, the Gini coefficient is zero
If income is perfectly unevenly distributed, the Gini coefficient is one
US has Gini coefficient of 0.466
Kuznets Curve: England and Wales 1823-1915
World Income Inequality
We have seen that growth can
widen income inequality within a
country
But if poor economies grow faster,
income inequality across countries
will be reduced
Especially if largest poor countries
grow fastest
Which effect dominates (within
countries versus across countries)?
Appears to be cross country effect
dominates