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ADVANCED MACKOECONOMICS This book was set in Lucida Bright by Publication Services, Inc. The editor was Lucille Sutton; the production supervisor was Friederich W. Schulte. The cover was designed by Delgado Des the cover illustration was drawn by Shane Kelley Project supervision was done by Publication Services. inc R. R. Donnelley & Sons Company was printer and binder. McGraw-Hill A Division of The McGraw-Hill Compames ADVANCED MACROECONOMICS Copyright © 1996 by The McGraw-Hill Companies, Inc. All rights reserved. Printed in the United States of America. Except as permitted under the United States Copyright Act of 1976, no part of this publication may be reproduced or distributed in any form or by any means, or stored in a data base or retrieval system, without the prior written permission of the publisher. This book is printed on acid-free paper. 7890DOC DOC 90987 ISBN 0-07-053667-8 Library of Congress Cataloginj Romer, David. Advanced macroeconomics / David Romer. p. cm. — (McGraw-Hill advanced series in economics) Includes bibliographical references and index. ISBN 0-07-053667-8 1. Macroeconomics. 1. Title. Il. Series. HBI72.5.R66 1996 339—de20 95-3728 ABOUT THE AUTHOR David Romer is professor of economics at the University of California, Berkeley. He received his A.B. from Princeton University, where he was vale- dictorian, and his Ph.D, from M.LT. He has been on the faculty at Princeton and has been a visiting faculty member at M.LT. and Stanford. He is also a Research Associate of the National Bureau of Economic Research and serves on the editorial boards of several economics journals. His main research in- terests are monetary policy, the foundations of price stickiness, empirical evidence on economic growth, and asset-price volatility. He is married to Christina Romer, who is also an economist, and has two children, Katherine and Paul. CONTENTS Acknowledgments Introduction Chapter 1 THE SOLOW GROWTH MODEL Theories of Economic Growth Assumptions The Dynamics of the Model The Impact of a Change in the Saving Rate Quantitative Implications ‘The Solow Model and the Central Questions of Growth Theory Empirical Applications Problems Chapter 2 BEHIND THE SOLOW MODEL: INFINITE-HORIZON AND OVERLAPPING-GENERATIONS MODELS Part A THE RAMSEY-CASS-KOOPMANS MODEL ea) — eS 24 = 2.6 = = = Assumptions The Behavior of Households and Firms The Dynamics of the Economy Welfare ‘The Balanced Growth Path The Effects of a Fall in the Discount Rate The Effects of Government Purchases Bond and Tax Finance ‘The Ricardian Equivalence Debate xix uw w 12 15 18 23 26 34 38 39 se 40 46 aE ape = 64 66 xii ~=CONTENTS Part B_ THE DIAMOND MODEL 72 2.10 Assumptions 72 2.11 Household Behavior 73 2.12 The Dynamucs of the Economy 75 2.13 The Possibility of Dynamic Inefficiency 81 2.14 Government in the Diamond Model 85 Problems 88 Chapter 3 BEYOND THE SOLOW MODEL: NEW GROWTH THEORY 95 Part A RESEARCH AND DEVELOPMENT MODELS 96 3.1 Framework and Assumptions 96 3.2 The Model without Capital 98 3.3. The General Case 104 3.4. The Nature of Knowledge and the Determinants of the Allocation of Resources to R&D il 3.5 Endogenous Saving in Models of Knowledge Accumulation: An Example 118 3.6 Models of Knowledge Accumulation and the Central Questions of Growth Theory 121 3.7 Empirical Application: Population Growth and Technological Change since 1 Million a. 122 Part B_ HUMAN CAPITAL 126 3.8 Introduction 126 3.9 A Model of Human Capital and Growth 128 3.10 Implications 132 3.11 Empirical Application: Physical and Human Capital Accumulation and Cross-Country Differences in Incomes 137, Problems 140 Chapter 4 REAL-BUSINESS-CYCLE THEORY 146 4.1 Introduction: Some Facts about Economic Fluctuations 146 4.2 Theories of Fluctuations 150 4.3. A Baseline Real-Business-Cycle Model 152 4.4 Household Behavior 154 4.5 A Special Case of the Model 158 4.6 — Solving the Model in the General Case 164 47 48 aes 4.10 CONTENTS Implications Empirical Application: The Persistence of Output Fluctuations Additional Empirical Applications Extensions and Limitations Problems Chapter 5 TRADITIONAL KEYNESIAN THEORIES 5.1 a El 5.4 = 5.6 OF FLUCTUATIONS Introduction Review of the Textbook Keynesian Model of Aggregate Demand The Open Economy Alternative Assumptions about Wage and Price Rigidity Output-Inflation Tradeoffs Empirical Application: Money and Output Problems: Chapter 6 MICROECONOMIC FOUNDATIONS Part A 6.1 6.2 63 64 Part B 6.5 66 67 68 69 Part C 6.10 6.11 6.12 6.13 OF INCOMPLETE NOMINAL ADJUSTMENT ‘THE LUCAS IMPERFECT-INFORMATION MODEL Overview The Case of Perfect Information The Case of Imperfect Information Implications and Limitations STAGGERED PRICE ADJUSTMENT Introduction A Model of Imperfect Competition and Price-Setting Predetermined Prices Fixed Prices The Caplin-Spulber Model NEW KEYNESIAN ECONOMICS, Overview Are Small Frictions Enough? The Need for Real Rigidity Empirical Applications xiii 168 175 180 183 190 195 195 197 205 214 222 232 236 241 242 242 243 246 250 256 256 caTE 262 265 7 276 276 278 ea ea xiv CONTENTS 6.14 Coordination-Failure Models and Real Non-Walrasian Theories 6.15 Limitations Problems Chapter 7 CONSUMPTION 71 = rae 7.4 rae 7.6 Consumption under Certainty: The Life-Cycle/ Permanent-Income Hypothe: Consumption under Uncertain Hypothesis Empirical Application: Two Tests of the Random-Walk Hypothesis The Interest Rate and Saving Consumption and Risky Assets Alternative Views of Consumption Problems : The Random-Walk Chapter 8 INVESTMENT 8.1 8.2 8.3 84 85 8.6 8.7 88 Investment and the Cost of Capital A Model of Investment with Adjustment Costs Tobin's q Analyzing the Model Implications ‘The Effects of Uncertainty: An Introduction Financial-Market Imperfections Empirical Applications Problems Chapter9 INFLATION AND MONETARY POLICY cal es 9.3 9.4 ce 96 9.7 9.8 Introduction Inflation, Money Growth, and Interest Rates Monetary Policy and the Term Structure of Interest Rates The Dynamic Inconsistency of Low-Inflation Monetary Policy Addressing the Dynamic-Inconsistency Problem Some Macroeconomic Policy Issues Seignorage and Inflation The Costs of Inflation Problems 294 300 302 309 310 316 a BP 328 332 341 345 345 348 353, 354 358 364 369 380 384 388 388 389 Be 398 403 412 420 429 433 CONTENTS xv Chapter 10 UNEMPLOYMENT 439 10.1 Introduction: Theories of Unemployment 439 10.2 A Generic Efficiency-Wage Model 441 10.3 A More General Version 446 10.4 The Shapiro-Stiglitz Model 450 10.5. Implicit Contracts : 461 10.6 Insider-Outsider Models 465 10.7 Hysteresis 469 10.8 Search and Matching Models 473 10.9 Empirical Applications 481 Problems 486 References 494 Name Index 523 Subject Index 528 Section 1.7 Section 2.7 Section 2.13 Section 3.7 Section 3.11 Section 4.8 Section 4.9 Section 5.6 Section 6.4 Section 6.13 Section 6.14 Section 7.1 Section 7.3 Section 7.5 Section 7.6 Section 8.8 Section 9.3 Section 9.5 Section 10,9 EMPIRICAL APPLICATIONS Growth Accounting Convergence Saving and Investment Investment, Population Growth, and Output Wars and Real Interest Rates Are Modern Economies Dynamically Ffficient? Population Growth and Technological Change Since 1 Million B.c Physical and Human Capital Accumulation and Cross-Country Differences in Incomes The Persistence of Output Fluctuations Calibrating a Real-Business-Cycle Model Productivity Movements in the Great Depression Money and Output International Evidence on Output-Inflation Tradeoffs The Average Inflation Rate and the Output-Inflation Tradeoff Supply Shocks Microeconomic Evidence on Price Adjustment Experimental Evidence on Coordination-Failure Games Understanding Estimated Consumption Functions Campbell and Mankiw's Test of the Random-Walk Hypothesis Using Aggregate Data Shea's Test of the Random-Walk Hypothesis Using Household Data The Equity-Premium Puzzle Liquidity Constraints and Aggregate Saving Buffer-Stock Saving The Investment Tax Credit and the Price of Capital Goods Cash Flow and Investment The Response of the Term Structure to Changes in the Federal Reserve's Federal-Funds-Rate Target Central-Bank Independence and Inflation Contracting Effects on Employment Interindustry Wage Differences XVii 26 27 31 32 61 84 122 137 175 180 182 232 253 289 291 293 297 312 319 322 330 338 339 380 381 396 409 481 484 ACKNOWLEDGMENTS This book owes a great deal to many people. The book is an outgrowth of courses I have taught at Princeton, M.LT., Stanford, and especially Berkeley. 1 want ta thank the many students in these courses for their feedback, their patience, and their encouragement. Four people provided detailed, thoughtful, and constructive comments on almost every aspect of the book: Laurence Ball, A. Andrew John, N. Gre- gory Mankiw, and Christina Romer. Each of them significantly improved the book, and | am deeply grateful to them for their efforts. In addition, Susanto Basu, Matthew Cushing, Charles Engel, Mark Gertler, Mary Gregory, A. Stephen Holland, Gregory Linden, Maurice Obtsfeld, and Robert Rasche made valuable comments and suggestions concerning some or all of the book. Jeffrey Rohaly not only prepared the superb Solutions Manual to accompany the book, but also read the page proofs with great care and made many corrections. Teresa Cyrus helped with the preparation of some of the tables and figures. Finally, the editorial staff at McGraw-Hill and the production staff at Publication Services, Inc., especially Leon Jeter, Victoria Richardson, Scott Schriefer, Scott Stratford, and Lucille Sutton, did an excellent job of turning the manuscript into a finished product. | thank all of these people for their help. xix INTRODUCTION Macroeconomics is the study of the economy as a whole. It is therefore concerned with some of the most important questions in economics. Why are some countries rich and others poor? Why do countries grow? What are the sources of recessions and booms? Why is there unemployment, and what determines its extent? What are the sources of inflation? How do gov- ernment policies affect output, unemployment, and inflation? These and related questions are the subject of macroeconomics. This book is an introduction to the study of macroeconomics at an ad- \anced level. It presents the major theories concerning the central questions of macroeconomics. Its goal is to provide both an overview of the field for students who will not continue in macroeconomics and a starting point for students who will go on to more advanced courses and research in macro- economics and monetary economics. The book takes a broad view of the subject matter of macroeconomic: it views it as the study not just of aggregate fluctuations but of other fea- tures of the economy as a whole. A substantial portion of the book is de- soted to economic growth, and separate chapters are devoted to theories of the natural rate of unemployment and to theories of inflation. Within each part, the major issues and competing theories are presented and discussed. Throughout, the presentation is motivated by substantive questions about the world. Models and techniques are used extensively, but they are treated as tools for gaining insight into important issues, not as ends in themselves. The first three chapters are concerned with growth. The analysis focuses on two fundamental questions: Why are some economies so much richer than others, and what accounts for the huge increases in real incomes over time? Chapter 1 is devoted to the Solow growth model, which is the basic reference point for almost all analyses of growth. The Solow model takes technological progress as given and investigates the effects of the division of output between consumption and investment on capital accumulation and growth. The chapter presents and analyzes the model and assesses its ability to answer the central questions concerning growth. Chapter 2 relaxes the Solow model's assumption that the saving rate is exogenous and fixed. It covers both a model where the set of households 2 INTRODUCTION in the economy 1s fixed (the Ramsey model) and one where there is turnover (the Diamond model). Chapter 3 presents the new growth theory, The first part of the chapter explores the sources of the accumulation of knowledge, the allocation of resources to knowledge accumulation, and the effects of that accumulation on growth. The second part investigates the accumulation of human as well as physical capital. Chapters 4 through 6 are devoted to short run fluctuations—the year-to- year and quarter-to-quarter ups and downs of employment, unemployment, and output. Chapter 4 investigates models of fluctuations where there are no imperfections, externalities, or missing markets, and where the economy 1s subject only to real disturbances. This presentation of real-business-cycle theory considers both a baseline model whose mechanics are fairly trans- parent and a more sophisticated model that incorporates additional impor- tant features of fluctuations. Chapters 5 and 6 then turn to Keynesian models of fluctuations. These models are based on sluggish adjustment of nominal wages and prices, and emphasize monetary as well as real disturbances, Chapter 5 takes the exis: tence of sluggish adjustment as given It first reviews the closed-economy and open-economy versions of the traditional /S-LM model. It then inves- tigates the imphcations of alternative assumptions about price and wage rigidity, market structure, and inflationary expectations for the cychcal be- havior of real wages, productivity, and markups, and for the relationship between output and inflation. Chapter 6 examines the fundamental assumption of Keynesian models that nominal wages and prices do not adjust immediately to disturbances, The chapter covers the Lucas imperfect-information model, models of stag- gered adjustment of prices or wages, and new Keynesian theories of small frictions in price-setting. The chapter concludes with a brief discussion of theories of fluctuations based on coordination failures and real non- Walrasian features of the economy. The analysis in the first six chapters suggests that the behavior of con- sumpton and investment is central to both growth and fluctuations. Chap- ters 7 and 8 therefore investigate the determinants of consumption and in- vestment in more detail. In each case, the analysis begins with a baseline model and then considers alternative views, For consumption, the baseline 1s the hfe-cycle/permanent-ncome hypothesis; for mvestment, its q theory. The fmal two chapters are devoted to mflation and unemployment. Chapter 9 begins by explammg the central role of money growth m causing inflation and by mvestigating the effects of money growth on inflation, interest rates, and the real money stock. The remainder of the chapter considers two sets of theories of the sources of high money growth: theo- ries emphasizing output-inflation tradeoffs (particularly theories based on the dynamic inconsistency of low-inflation monetary policy), and theories emphasizing governments’ need for revenue from money creation. INTRODUCTION 3 The main subject of Chapter 10 is the determinants of an economy's nat- ural rate of unemployment. The chapter also investigates the impact of fluc- tuations in labor demand on real wages and employment. The main theories considered are efficiency-wage theories, contracting and insider/outsider theories, and search and matching models.' Macroeconomics is both a theoretical and an empirical subject. Because of this, the presentation of the theories is supplemented with examples of relevant empirical work. Even more so than with the theoretical sections, the purpose of the empirical material is not to provide a survey of the literature; nor is it to teach econometric techniques. Instead, the goal is to illustrate some of the ways that macroeconomic theories can be applied and tested. The presentation of this material is for the most part fairly intuitive and presumes no more knowledge of econometrics than a general familiarity with regressions. In a few places where it can be done naturally, the empir- ical material includes discussions of the ideas underlying more advanced econometric techmiques. Each chapter concludes with an extensive set of problems. The problems range from relatively straightforward variations on the ideas in the text to extensions that tackle important new issues. The problems thus serve both as a way for readers to strengthen their understanding of the material and as a compact way of presenting significant extensions of the ideas in the text? The fact that the book is an advanced introduction to macroeconomics has two main consequences. The first is that the book uses a series of for- mal models to present and analyze the theories. Models identify particular features of reality and study their consequences in isolation. They thereby allow us to see clearly how different elements of the economy interact and what their implications are. As a result, they provide a rigorous way of in- \ estigating whether a proposed theory can answer a particular question and whether it generates additional predictions. The book contains hterally dozens of models. The main reason for this multiplicity is that we are interested in many issues. The features of the economy that are crucial to one issue are often unimportant to others. Money, for example, is almost surely central to inflation and is probably not central to long-run growth. Incorporating money into models of growth would only obscure the analysis. Thus instead of trying to build a single The chapters are largely independent. The growth and fluctuations sections are almost entirely self-contained (although Chapter 4 builds moderately on Part A of Chapter 2). There 1» also considerable independence among the chapters in each section. New growth theory «Chapter 3) can be covered either before or after the Ramsey and Diamond models (Chapter 2), and Keynesian models (Chapters 5 and 6) can be covered either before or after real busmness-cycle theory (Chapter 4). Finally, the last four chapters are largely self-contained ‘although Chapter 7 rehes moderately on Chapter 2, Chapter 9 relies moderately on Chapter 5, and Chapter 10 relies moderately on Chapter 6). *A solutions manual prepared by Jeffrey Rohaly 1s available for use with the book. 4 INTRODUCTION model to analyze all of the issues we are interested in, the book develops a series of models. An additional reason for the multiplicity of models 1s that there 1s con- siderable disagreement about the answers to many of the questions we will be examining When there 1s disagreement, the book presents the leading views and discusses their strengths and weaknesses. Because different the- ories emphasize different features of the economy, again it is more enlght- ening to mvestigate distinct models than to build one model incorporating all of the features emphasized by the different views. The second consequence of the book’s advanced level is that it presumes some background in mathematics and economics. Mathematics provides compact ways of expressing ideas and powerful tools for analyzing them. The models are therefore mamly presented and analyzed mathematically. The key mathematical requirements are a thorough understanding of single- variable calculus and an introductory knowledge of multivariable calculus. Tools such as functions, logarithms, derivatives and partial derivatives, maximization subject to constramt, and Taylor-series approximations are used relatively freely. Knowledge of the basic ideas of probability—random variables, means, variances, covariances, and independence—is also as- sumed. No mathematical background beyond this level 1s needed. More advanced tools (such as simple differential equations, the calculus of variations, and dynamic programmung) are used sparingly, and they are explained as they are used. Indeed, since mathematical techniques are essential to further study and research in macroeconomics, models are sometimes analyzed in more detail than 1s otherwise needed in order to illustrate the use of a particular method. In terms of economics, the book assumes an understanding of microeco- nomics through the intermechate level. Familiarity with such ideas as profit- maximization and utlity-maxmuzation, supply and demand, equilibrium, efficiency, and the welfare properties of competitive equihbria 1s presumed. Little background in macroeconomics itself 1s absolutely necessary. Read- ers with no prior exposure to macroeconomics, however, are hkely to find some of the concepts and termmology difficult, and to find that the pace 1s rapid (most notably in Chapter 5). These readers may wish to review an intermediate macroeconomics text before beginning the book, or to study such a book in conjunction with this one. The book was designed for first-year graduate courses in macroeco- nomucs. But it can be used in more advanced graduate courses, and (either on its own or m conjunction with an intermediate text) for students with strong backgrounds in mathematics and economics in professional schools and advanced undergraduate programs. It can also provide a tour of the field for economists and others working in areas outside macroeconomics. Chapter 1 THE SOLOW GROWTH MODEL 1.1 Theories of Economic Growth Standards of living differ among parts of the world by amounts that almost defy comprehension. Although precise comparisons are difficult, the best available estimates suggest that average real incomes in such countries as the United States, Germany, and Japan exceed those in such countries as Bangladesh and Zaire by a factor of twenty or more. There are also large differences in countries’ growth records. Some countries, such as South Ko- rea, Turkey, and Israel, appear to be making the transition to membership in the group of relatively wealthy industrialized economies. Others, includ- ing many in South America and sub-Saharan Africa, have difficulty simply in obtaining positive growth rates of real income per person. Finally, we see vast differences in standards of living over time: the world is much richer today than it was three hundred years ago, or even fifty years ago. The implications of these differences in standards of living for human. welfare are enormous. The real income differences across countries are as- sociated with large differences in nutrition, literacy, infant mortality, life expectancy, and other direct measures of well-being. And the welfare con- sequences of long-run growth swamp any possible effects of the short-run fluctuations that macroeconomics traditionally focuses on. During an av- erage recession in the United States, for example, real income per person. falls by a few percent relative to its usual path. In contrast, the productiv- ity slowdown—the fact that average annual productivity growth since the 1970s has been about 1 percentage point below its previous level—has re- duced real income per person in the United States by about 20 percent rel- ative to what it otherwise would have been. Other examples are even more startling. If real income per person in India continues to grow at its postwar average rate of 1.3 percent per year, it will take about two hundred years for Indian real incomes to reach the current U.S. level. If India achieves 3 percent growth, the process will take less than one hundred years. And if it achieves Japan's average growth rate, 5.5 percent, the time will be reduced to only fifty years. To quote Robert Lucas (1988), “Once one starts to think about [economic growthl, it is hard to think about anything else.” 6 Chapter 1 THE SOLOW GROWTH MODEL The first three chapters of this book are therefore devoted to economic growth. We will investigate several models of growth. Although we will ex- amine the models’ mechanics in considerable detail, our ultimate goal is to learn what insights they offer concerning worldwide growth and income differences across countries. This chapter focuses on the model that economists have traditionally used to study these es, the Solow growth model.! The Solow model is the starting point for almost all analyses of growth. Even models that depart fundamentally from Solow’s are often best understood through comparison with the Solow model. Thus understanding the model is essential to under- standing theories of growth. The principal conclusion of the Solow model is that the accumulation of physical capital cannot account for either the vast growth over time in output per person or the vast geographic differences in output per person Specifically, suppose that the mechanism through which capital accumula- tion affects output is through the conventional channel that capital makes a direct contribution to production, for which it is paid its marginal product. Then the Solow model implies that the differences in real incomes that we are trying to understand are far too large to be accounted for by differences in capital inputs. The model treats other potential sources of differences in real incomes as either exogenous and thus not explained by the model (in the case of technological progress, for example), or absent altogether (in the case of positive externalities from capital, for example), Thus to address the central questions of growth theory we must move beyond the Solow model. Chapters 2 and 3 therefore extend and modify the Solow model. Chapter 2 investigates the determinants of saving and investment. The Solow model has no optimization in it; it simply takes the saving rate as exogenous and constant. Chapter 2 presents two models that make saving endogenous and potentially time-varying. In the first, saving and consumption decisions are made by infinitely-lived households; in the second, they are made by house- holds with finite horizons. Relaxing the Solow model’s assumption of a constant saving rate has three advantages. First, and most important for studying growth, it demon- strates that the Solow model's conclusions about the central questions of growth theory do not hinge on its assumption of a fixed saving rate. Second, it allows us to consider welfare issues. A model that directly specifies rela- tions among aggregate variables does not provide a way to judge whether some outcomes are better or worse than others: without individuals in the model, we cannot say whether different outcomes make individuals bet- ter or worse off. The infinite-horizon and finite-horizon models are built up from the behavior of individuals, and can therefore be used to discuss welfare issues. Third, infinite- and finite-horizon models are used to study 'The Solow model—sometimes known as the Solow-Swan model—was developed by Robert Solow (Solow, 1956) and T. W. Swan (Swan, 1956). 1.2 Assumptions 7 many issues in economics other than economic growth; thus they are valu- able tools. Chapter 3 investigates more fundamental departures from the Solow model. Its models, in contrast to Chapter 2's, provide different answers than the Solow model does to the central questions of growth theory. The models depart from the Solow model in two basic ways. First, they make technolog- ical progress endogenous. We will investigate various models where growth ‘occurs as the result of conscious decisions on the part of economic actors to invest in the accumulation of knowledge. We will also consider the deter- minants of the decisions to invest in knowledge accumulation. Second, the models examine the possibility that the role of capital is con- siderably larger than is suggested by considering physical capital's share in income. This can occur if the capital relevant for growth is not just physical capital but also human capital. It can also occur if there are positive exter- nalities from capital accumulation, so that what capital earns in the market understates its contribution to production. We will see that models based on endogenous technological progress and on a larger role of capital pro- vide candidate explanations of both worldwide growth and cross-country ancome differences. We now turn to the Solow model. 1.2 Assumptions Inputs and Output The Solow model focuses on four variables: output (Y), capital (K), labor +L), and “knowledge” or the “effectiveness of labor” (A). At any time, the economy has some amounts of capital, labor, and knowledge, and these are combined to produce output. The production function takes the form Y(t) = F(K(t), A(OL(O), aD where t denotes time. Two features of the production function should be noted. First, time does not enter the production function directly, but only through K, L, and A. That is, output changes over time only if the inputs into production change. In particular, the amount of output obtained from given quantities of capital and labor rises over time—there is technological progress—only if the amount of knowledge increases. Second, A and L enter multiplicatively. AL is referred to as effective labor, and technological progress that enters in this fashion is known as labor-augmenting or Harrod-neutral This way of specifying how A enters *If knowledge enters in the form Y = F(AK,1), technological progress is capital augmenting. If it enters in the form Y = AF(K, L), technological progress is Hicks-neutral. 8 Chapter 1 THE SOLOW GROWTH MODEL together with the other assumptions of the model, will imply that the ratio of capital to output, K/Y, eventually settles down. In practice, capital- output ratios do not show any clear upward or downward trend over extended periods. In addition, building the model so that the ratio is eventu- ally constant makes the analysis much simpler. Assuming that A multiplies Lis therefore very convenient. The central assumptions of the Solow model concern the properties of the production function and the evolution of the three inputs into produc- tion (capital, labor, and knowledge) over time. We discuss each in turn. Assumptions Concerning the Production Function The model's critical assumption concerning the production function is that it has constant returns to scale in its two arguments, capital and effective la- bor. That is, doubling the quantities of capital and effective labor (for exam- ple, by doubling K and Z with A held fixed) doubles the amount produced. More generally, multiplying both arguments by any nonnegative constant c causes output to change by the same factor: F(cK,cAL) = cF(K,AL) forall c = 0. ~ (1.2) The assumption of constant returns can be thought of as combining two assumptions. The first is that the economy is big enough that the gains from specialization have been exhausted. In a very small economy, there are probably enough possibilities for further specialization that doubling the amounts of capital and labor more than doubles output. The Solow model assumes, however, that the economy is sufficiently large that, if capital and labor double, the new inputs are used in essentially the same way as the existing inputs, and thus that output doubles. The second assumption is that inputs other than capital, labor, and knowledge are relatively unimportant. In particular, the model neglects Jand and other natural resources. If natural resources are important, dou- bling capital and labor could less than double output. In practice, however, the availability of natural resources does not appear to be a major con- straint on growth. Assuming constant returns to capital and labor alone therefore appears to be a reasonable approximation.’ The assumption of constant returns allows us to work with the produc- tion function in intensive form. Setting c = 1/AL in equation (1.2) yields (K\_ Lae ; F (52) = Srwan. (1.3) %Growth accounting, which is described in Section 1.7, can be used to formalize the ‘argument that natural resources are not very important to growth. Problem 1.10 investigates a simple model where natural resources cause there to be diminishing returns to capital and Jabor. Finally, Chapter 3 examines the implications of increasing returns. 1.2 Assumptions 9 K /ALis the amount of capital per unit of effective labor, and F(K, AL)/AL is Y/AL, output per unit of effective labor. Define k ~ K /AL, y = Y/AL, and f(k) = F(k, 1). Then we can rewrite (1.3) as y = fk). (4) That is, we can write output per unit of effective labor as a function of capital per unit of effective labor. To see the intuition behind (1.4), think of dividing the economy into AL small economies, each with 1 unit of effective labor and K / AL units of capi- tal. Since the production function has constant returns, each of these small economies produces 1/AL as much as is produced in the large, undivided economy. Thus the amount of output per unit of effective labor depends only on the quantity of capital per unit of effective labor, and not on the overall size of the economy. This is what is expressed mathematically in equation (1.4). If we wish to find the total amount of output, as opposed to the amount per unit of effective labor, we can multiply by the quantity of effective labor: Y = ALf(k). The intensive-form production function, f(k), is assumed to satisfy (0) = 0, f’(k) > 0, f"(k) < 0.4 It is straightforward to show that f'(k) is the marginal product of capital: since F(K, AL) = ALf(K/AL), 4F(K /AL)/aK = ALf'(K /AL\(1/AL) = f'(k). Thus these assumptions imply that the marginal product of capital is positive, but that it declines as capital (per unit of effective labor) rises. In addition, f(+) is assumed to satisfy the Inada con- ditions (Inada, 1964): limg—o f’(k) = 0, limy.. f’(k) = 0. These conditions «which are stronger than is needed for the model's central results) state that the marginal product of capital is very large when the capital stock is sufficiently small and that it becomes very small as the capital stock becomes large; their role is to ensure that the path of the economy does not diverge. A production function satisfying f’(*) > 0, f’"(*) < 0, and the Inada conditions is shown in Figure 1.1 A specific example of a production function is the Cobb-Douglas: F(K,AL) = KAD", O Note that with Cobb-Douglas production, labor-augmenting, capital-augmenting, and. -neutral technological progress (see n. 2) are all essentually the same. For example, to rewrite (1.5) so that technological progress 1s Hicks-neutral, simply define A = A'~*; then (KL,

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