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Lecture 7:

History and Causes of Growth


September 22, 2015

Prof. Wyatt Brooks

Causes of Growth
Before: Looked at special cases and tried to
qualitatively understand causes of growth

Now evaluate causes of growth quantitatively


Motivating question: How important is history?
That is, if a country has always been poor, are they at a
disadvantage relative to one that has been rich?

Solow Growth Model

Robert Solow
Macroeconomist
Professor at MIT
Nobel Prize (1987)

Important Contributions:
Developed a macroeconomic
model that allows for a
decomposition of GDP into
factors of production (capital,
labor, productivity)
Showed that capital
accumulation is relatively
unimportant for growth
Contrasts with the thinking of
the majority of economists
before (Smith, Marx, etc.)

Macroeconomic Models
Models: A theoretical construct designed to represent a
complex system.
Economists use these models to predict the effects of
policy, such as:
If taxes are raised, what will happen to
unemployment?
Who will gain and lose from a free trade
agreement?
What happens to unemployment if the Federal
Reserve increases the supply of money in the
economy?
What policies can increase growth in developing
countries?

Key Features of a Macroeconomic Model


Consumers: Represent households who supply
labor, make investments and consume

Firms: Represent all businesses who use factors of


production (labor, capital, land, etc.) to produce
output
Equilibrium: The outcome of the model.
A prediction about how firms and consumers interact
through markets

Solow Growth Model


Observation: Richer countries have more capital
(more machines, factories, etc.)
Is this the cause or the result of their greater income?
Two possibilities considered:
Countries have more capital because they save a
greater part of their income
Countries have more capital because the return on
investing in capital is higher
The whole model is beyond the scope of this class, so
we will consider a greatly simplified version

Simplified Solow Growth Model


Consumers:
Consume a constant fraction of GDP and own
all the capital in the economy
Not modeling:
Unemployment (everyone always works)
Lifecycle (no children, students or retirees)
Within-country income inequality
Consumers described by one equation:
I=sY
where s, a number between 0 and 1, is the
fraction of output that gets invested.

Simplified Solow Growth Model


Firms:
Use the capital to produce output
Not modeling:
Labor markets (searching for workers)
Finance (borrowing to take on projects)
Executive compensation
Firms described by one equation:
Y = A K0.3
where Y is GDP, A is productivity
and K is the capital stock

Simplified Solow Growth Model


Equilibrium:
All output is used either in investment or
consumption (no trade, no government):
Y=C+I
How the stock of capital changes over time:
K = I + (1- )K
where K is the capital stock next year,
K is the capital stock this year,
I is investment this year, and
is the depreciation rate

Simplified Solow Growth Model


So the entire model is described by four
equations:

Households:
Firms:
Capital Accumulation:
GDP:

I=sY
Y = A K0.3
K = I + (1- )K
Y=C+I

Rearranging terms:
I = s Y = s A K0.3
K = I + (1- )K = s A K0.3 + (1- )K

How does the capital stock


change over time?
K

How are capital this year, and


capital next year related?

K= K

How does the capital stock


change over time?
K
K = s A K0.3 + (1- )K

K= K

The equation above tells you


how much capital there will be
next year

How does the capital stock


change over time?
K
K = s A K0.3 + (1- )K

Suppose the economy starts


with some low capital level K0

K= K

K0

How does the capital stock


change over time?
K
K = s A K0.3 + (1- )K

K1

K= K

K0

Then the equation says that


next years capital stock will
be K1

How does the capital stock


change over time?
K
K = s A K0.3 + (1- )K

K1

K= K

K0

K1

Using the red 45 degree line


as a reference, we can find
K1 on the horizontal axis.

How does the capital stock


change over time?
K
K = s A K0.3 + (1- )K
K2

Then we can find K2

K1

K= K

K0

K1

How does the capital stock


change over time?
K
K = s A K0.3 + (1- )K
K2
K1

K= K

K0

K1

Repeating these steps, we


can find the capital stock in
any future year

How does the capital stock


change over time?
K
K = s A K0.3 + (1- )K
K2

Repeating these steps, we


can find the capital stock in
any future year

K1

K= K

K0

K1

K2

How does the capital stock


change over time?
K
K = s A K0.3 + (1- )K
K3
K2

Repeating these steps, we


can find the capital stock in
any future year

K1

K= K

K0

K1

K2

How does the capital stock


change over time?
K
K = s A K0.3 + (1- )K
K3
K2

Repeating these steps, we


can find the capital stock in
any future year

K1

K= K

K0

K1

K2 K3

How does the capital stock


change over time?
K
K = s A K0.3 + (1- )K

K4
K3
K2

Repeating these steps, we


can find the capital stock in
any future year

K1

K= K

K0

K1

K2 K3

How does the capital stock


change over time?
K
K10
.
K3
K2

K = s A K0.3 + (1- )K

Notice that the capital stock


is approaching the point
where the two lines meet

K1

K= K

K0

K1

K2 . K10

How does the capital stock


change over time?
K
K*

K = s A K0.3 + (1- )K
The point where the two
lines meet is the steady
state level of capital. Once
the economy is at this level,
the capital level does not
change.

K= K

K*

Some Things to Notice


The further the economy starts below the steady
state level of capital, the faster the economy
initially grows
Mankiw refers to this as the catch-up effect
This is due to the effect of diminishing returns
The amount of extra output from each
additional unit of capital goes down as the
capital stock gets larger
Growth slows over time until the capital stock
reaches the steady state level

Savings and Productivity


What happens if the savings rate of the country
changes?
Increase s from its initial level to a higher level

Increase in the Savings Rate


K
K*

K = s A K0.3 + (1- )K
Suppose the economy is in
a steady state with savings
rate s.

K= K

K*

Increase in the Savings Rate


K

K = s A K0.3 + (1- )K

K*
Then the savings rate
increases to s.

K= K

K*

Increase in the Savings Rate


K

K = s A K0.3 + (1- )K

K1
Now capital accumulates
according to the new
equation with the higher
savings rate

K= K

K*

Increase in the Savings Rate


K

K = s A K0.3 + (1- )K

K1

And we proceed
exactly like before.

K= K

K*

Increase in the Savings Rate


K

K = s A K0.3 + (1- )K

K*
K0
Eventually a new,
higher steady state
capital stock is
reached.

K= K

K0

K*

Savings and Productivity


What happens if instead productivity is
increased?
Same thing.
Income goes up, so consumers have more to
invest, which increases the capital stock.

How are they different?


Higher savings: Decreases consumption
today, increases it (maybe) in the future
Higher productivity: Increases consumption
both today and in the future

120000

100000

GDP per Capita

80000

60000

40000

20000

0
-20

-10

10

20

30

Savings Rate

40

50

60

70

Savings and Productivity


Back to what Solow found:
Savings rates (even historical) have little
relationship to relative wealth
Apparently the wealth of countries that are
now rich is not because of long term savings
and investment per se
That is, clearly the fact that rich countries are
rich is partly because they have more
capital. BUT they have more capital because
they have high productivity.

Savings and Productivity


This is an extremely important finding.
Suggests that a long history of capital
accumulation is not necessary to be wealthy
If a country is able to increase its productivity,
capital will catch up quite quickly
This shifted the emphasis in the study of
promoting development in low income countries
away from trying to send them capital, and toward
trying to make their economies more efficient
How do you do that?
Perhaps the most important open question in
economics.

More Direct: Growth Accounting


Now take the basic Solow model and extend it to
include labor and human capital
Decompose changes in GDP per capita using this
production function:

Y = A K1/3H2/3

Here, H is human capital: h x L


h is average human capital
L is the number of workers
N is total population

1.5
=

0.5

Sources of Growth?
Growth through savings:
Increases in GDP driven by higher K/Y

Growth through productivity:


Increases in GDP driven by higher A
K/Y is roughly constant (as in Solow)
Other possibilities:
Labor: L/N

Human capital: h

USA Growth Accounting


400

200

Y/N

K/Y^(1/2)
h
L/N
100

50
1950

A^(3/2)

1960

1970

1980

1990

2000

2010

China Growth Accounting


3200

1600

800

Y/N

K/Y^(1/2)
400

h
L/N

200

A^(3/2)

100

50
1950

1960

1970

1980

1990

2000

2010

South Korea Growth Accounting


3200

1600

800

Y/N

K/Y^(1/2)
400

h
L/N

200

A^(3/2)

100

50
1960

1970

1980

1990

2000

2010

Argentina Growth Accounting


400

200

Y/N

K/Y^(1/2)
h
L/N
100

50
1950

A^(3/2)

1960

1970

1980

1990

2000

2010

Zimbabwe Growth Accounting


400

200

Y/N

K/Y^(1/2)
100

h
L/N
A^(3/2)

50

25
1960

1970

1980

1990

2000

2010

Findings
In growing countries, growth is not driven by K/Y,
its driven by A

In non-growing countries, big fluctuations in all of


the factors
Why does A go up in growing countries?

Look to histories
Improvements in technology
Improvements in institutions