SOLOW GROWTH MODEL

There is a study conducted by Dante Canlas that opens up an investigation of economic growth in the Philippines using
annual time-series data on per capita GDP. The study takes off from the contribution to growth theory of Robert Solow
(1956). A casual look at some comparative figures on savings, population growth, and education suggests that these
variables matter in accounting for growth in a sample of East and Southeast Asian economies. The Solow model predicts
that the effect of the saving rate on per capita output is positive while that of population growth, negative.

The rapid annual population growth rate in the Philippines has yielded an age distribution structure that is concentrated
at the younger age cohorts. Such age distribution is bound to affect variables that influence economic growth. With a
preponderantly young population, for instance, the child-dependency ratio tends to be high, resulting in high
consumption, low savings, and reduced investments not only in physical capital, but also in human capital, especially
education.

The study has been an attempt to interpret time-series data on real per capita GDP in the Philippines using the Solow
growth model. The predictions of the Solow model on savings and population growth rate seem supported. The
predictions on the growth effects of human capital is only weakly supported; the sign is as expected but not statistically
significant. The results suggest that public policy aimed at raising savings and investments, accumulating human capital,
and slowing down population growth continue to be relevant for long-run economic growth.

PHILIPS CURVE

The so-called Phillips curve postulates a trade-off between inflation and unemployment. There is a study
conducted that detects a long run negative and a casual realationship between inflation rates and unemployment
in the Philippines. In other words, the study offered an additional support for the existence of the Philips curve
in the developing countries, such as the Philippines. In the Philippines, headline CPI inflation and the
unemployment rate for 2017 averaged 3.2% yoy and 5.7%. The Philippine Phillips curve has relatively flattened
in light of the conduct of inflation targeting. For the Philippines, there is empirical evidence about the existence
of the Phillips curve. However, a central bank study has highlighted a flattening of the curve over the years and
may have partly been a result of the central bank’s adoption of inflation targeting in 2002. Using Philippine data
there is statistical evidence that found out inflation has significantly gone down during the inflation targeting
era, which spans the 2002-2017 period. There is also a measurement of inflation volatility over the years and
found that it was substantially higher during the pre-inflation targeting period (1977-2001) than during the post-
inflation targeting era. With this regard, inflation targeting has indeed helped mitigate inflation volatility and
anchored inflation expectations, and therefore has contributed to the flattening of the Phillips curve in the
Philippines.

OLG MODEL

The OLG model provides a useful framework to analyze the effect of various government policies.
There are two types of different retirement systems that we can relate with the Philippines: a fully funded system versus
a pay as you go system. A fully funded system is one that collects funds from the young for the social security system to
invest. When the young retires, the gross return from investment becomes the social security. A pay as you go system is
one that collects funds from the young for the old to consume. In a fully funded system, let s be the retirement tax or
social security tax. When they retire, they receive the fund and earnings from investment. The budget constraint
changes such that the young disposes income wage by consuming, saving and paying the retirement system. Upon
retirement, this individual receives private savings, returns to private investment, social security contribution, and
returns to public investment. She disposes this by consuming all. Changing the social security tax has no effect on the
capital stock. In other words, a fully funded system of retirement does not change the supply of capital stock. The
justification follows. In a fully funded system, the social security system collects part of income that individuals would
have invested. The system then invests the money collected elsewhere. While the economic agent investing the money
changed, the amount of investment does not change. Thus, capital accumulation remains the same. A Pay As You Go
System is one that collects funds from the young for the old to consume. In other words, those young and working today
pay social security. The government then gives the social security collected to those older and retired. When the former
retires, they receive funds collected from the next generation. The budget constraint changes such that the young
disposes income wage by consuming, saving and paying the retirement system. Upon retirement, this individual receives
savings, returns to private savings and retirement fund. She disposes this by consuming all. Note that the social security
tax does not get interest return because the authority does not invest the money but rather gives it to the older
generation to consume. The previous two can be combined through their third rearrangements. In effect, consumer
savings make up the economy’s capital stock since it is invested Social security tax has a negative effect on capital stock.
In other words, increasing the social security tax in a pay as you go system of retirement decreases the supply of capital
stock. Intuitively, investment decreases because part of the money individuals would have invested is taxed by
authorities for others to consume.

In reality the pension structure of most OECD countries is far more complex. Aside from government-sponsored welfare
programs that guarantee old-age-pension income, many individuals contribute to some form of private retirement
savings through their employers. The role of a private pension fund and the ways it is affected by demographic change is
distinguished from that of a government system. Private pension funds resemble firms in a sense that they maximize
expected returns by choosing an investment portfolio of equity and long-term bonds (Beetsma and Bucciol 2011). On
the other hand, the government finances public goods such as health care, education and public pension using revenue
from its tax-base (Kudrna et al. 2014; Lisenkova et al. 2013; Muto et al. 2012; and others). Demographic shifts affect
both the composition of the government’s spending, as well as the sources of its income, such as taxable wage-income.
A government operating in deficit must issue debt 𝐵𝑡 to finance its spending 𝐺𝑡 and repay the interest and principal in
subsequent periods. The constraints of the government are 𝐵𝑡 + 𝜏𝑡 = (1 + 𝑟𝐵)𝐵𝑡−1 + 𝐺𝑡 [16] where 𝜏𝑡 is tax raised in
period 𝑡 and 𝑟𝐵 is the rate of interest payable on government bonds. Individuals’ labour income decreases by the
amount of tax. 𝑤𝑡 − 𝜏𝑡 = 𝑐𝑡 + 𝑠𝑡 [17] As a result of public debt, the amount of private savings and investment in new
capital is lower. Notice, however, that this model specification gives rise to another type of asset in which individuals can
invest. 𝐾𝑡+1 = 𝑁𝑡𝑠𝑡 − 𝐵𝑡 [18] Return on Assets A key feature of our modern economy is the ability for individuals to
invest directly or indirectly in the financial markets through instruments such as stocks, bonds, houses, infrastructure,
and financial derivatives.

RAMSAY MODEL

The Solow model is a very important tool to understand the determinants of long term growth. Its main conclusion –
that long term growth in standards of living across countries and over time cannot be accounted for simply by the
accumulation of physical capital– is a key message. But the Solow model makes some important simplifying assumptions
along the way. One of the most striking simplification is that aggregate consumption is simply a linear function of
aggregate output, so that the fraction of output devoted to investment (=saving in a closed economy) is also constant.
This is really a strong assumption. An entire body of literature on consumption behaviour emphasizes that household
consumption is much more complex than simply a fixed proportion of income. In fact, Milton Friedman in 1976 and
Franco Modigliani in 1985 both won the Nobel Prize in Economics in part for their analysis of aggregate consumption
and saving behaviour. Ramsey or Cass-Koopmans model: differs from the Solow model only because it explicitly models
the consumer side and endogenizes savings. Infinite-horizon, continuous time. In Ramsay model it allows households to
make optimal consumption/saving decisions at the microeconomic level, given the environment they are facing. As a
result, the evolution of the capital stock will reflect the interactions between utility-maximizing households (supplying
savings) and profit-maximizing firms (demanding investment). In this model, the saving rate may not be constant
anymore. This model was originally developed by Frank P. Ramsey, a precocious mathematician and economist who died
at age 26! (1903-1930).The original Ramsey problem was a planning problem (i.e. the allocation of resources chosen
optimally by a planner that tries to maximize the utility of households). The model was later extended by David Cass and
Tjalling Koopmans in 1965 (in separate contributions) to a decentralized environment where households supply labor,
hold capital and consume optimally, given prices and wages, while firms rent capital, hire labor to maximize profits,
given prices and wages; and markets clear. The two approaches are identical, because there are no market
imperfections, so the first welfare theorem holds: the competitive, decentralized equilibrium is a solution to the planner
problem. Historically the model is often referred to as the Ramsey-Cass-Koopmans model.

Each household has to decide how much to consume and how much to save (in the form of capital accumulation). How
do they choose between various consumption sequences? By maximizing lifetime utility.

The intertemporal budget constraint faced by the household has a simple interpretation: the present value of
consumption has to be smaller than total wealth, defined as the present value of future labor income plus current
assets. Finally, the Transversality Condition simply says that it does not make sense to accumulate large amounts of
wealth. b(t)λ(t) can be interpreted as the quantity of wealth b(t) times its price (in utility terms) λ(t). So it represents the
shadow value of total wealth. If the limit term in (13) was strictly positive, it would mean that this wealth (measured in
utility terms) would grow faster than the discount rate. This is not optimal: the household would be better off
consuming more today and holding less wealth in the long run

Consumption per worker C(t) grows or decline depending on the difference between the interest rate r(t) and the
discount rate ρ. This reflects the effect of the two forces that shape consumption/saving decisions. On the one hand the
household is impatient and wants to consume now. On the other hand, postponing consumption today means more
consumption tomorrow. A higher interest rate makes savings more desirable. Therefore consumption tomorrow will be
higher than today’s consumption and consumption growth increases. When the interest rate r(t) equals the discount
factor ρ, the two forces balance out and the household will choose to leave consumption unchanged. Observe the role
of θ: as θ increases the IES is smaller and consumption growth is less responsive to the interest rate. This is because if
the intertemporal elasticity of substitution is lower, the household is less willing to adjust consumption in response to a
change in the interest rate. The Euler equation only pins down the ‘slope’ of consumption. The level of consumption will
be determined by the intertemporal budget constraint. The population growth rate n does not enter into these
expressions.

The Ramsey model maximizes the representative agent’s utility subject to constraint. Ultimately, the sacrificed utility
from consuming today equals the present value of tomorrow’s total gain for saving. At steady state, the marginal
product of capital exactly equals the sum of the rate of time preference and the rate of depreciation. Due to the rate of
time preference, the Ramsey model results to a lower capital accumulation than that of the Golden Rule.

Real Business Cycle (RBC)

The contribution of RBC to the Ramsey model is the insertion of productivity shock, zt, acting as random walk, except
with mean 1. Intuitively, as income (ztKt a ) increases, investment (Kt+1) increases by ab. By similar derivation, as income
increases, consumption increases by 1-ab. Thus ab and 1- ab represent the marginal propensity to invest and marginal
propensity to consume, respectively
The Philippine economy does behave consistently with RBC Model according to a study conducted by Luis F. Dumlao. His
study uses real GDP, in 1985 prices, as published by National Statistical Coordination Board (NCSB). It uses two versions:
the annual GDP and quarterly GDP, both from 1981 to 2001.
His data indicates economically sensible results in the following manner. First, all parameters seem significant. Second,
the signs agree with theory. All f1’s are positive and f2’s are negative. This means last period’s growth rate directly
affects the economy. Last 9 two period’s growth rate cyclically affects the economy. This goes consistently with the
economy’s cyclical behavior. Third, the absolute values of f1’s and f2’s are between zero and one. This makes past
growth rates and shocks transitional, rather than permanent and increasing. Fourth, the absolute values of f1’s are
greater than f2’s. This means last period’s growth rate has more effect than that of last two period’s on the present
economy. Fifth and finally, the results consistently indicate a specific level of steady state growth path. Theoretically, the
steady state growth rate equal the sum of rates of population growth and capital depreciation. The population growth
rate is approximately 2%. The rate of depreciation is some theoretical positive rate. Adding the two, the result is some
rate greater than 2%. Equations 11.4, 12.4, 13.4 and 14.4 indicate steady state growth rates of 2.25%, 2.34%, 2.19% and
2.22%. Not only are the numbers consistent at a certain level, the approximations also do not deviate from theory.

Any exogenous shock deviates the actual GDP from the long run equilibrium path of GDP. In addition, a shock today may
have an increasing lasting effect. That is to say a shock today affects the economy today, the economy next period more,
the next two periods even more, and so on. To adjust for this, the initial test equations adjust by adding a time trend
variable.

The theoretical criticisms of RBC remain the same as excess smoothness puzzle, excess volatility puzzle, lack of intuition
on employment and hysteresis, etc. the empirical challenge is how well will this model fair in forecasting economic
growth rate. Although the model gives forecast of future growth rate, such estimations are subject to the assumption
that no shocks occur in the future. In other words, it enables to predict based on the assumption that et+n (for all n >0)
is zero. Thus, the model necessitates some additional work to be able to estimate future shocks to incorporate to the
preliminary model. Economists can improve the forecast two ways. First is by traditional economic thought. Traditional
literature believes that the government may alter the growth of the economy. If traditional belief holds true,
economists may measure how economic policies, fiscal or monetary, may disrupt the cycle. Once measured, the degree
of disruption may be incorporated to the business cycle’s error term. Then, economists may predict how the economy
will evolve from this point on. The second is by policy ineffective thinking. A growing literature in economics argues that
systematic and traditional government policies like monetary and fiscal tools do not affect the economy. In other
words; fiscal deficit or surplus, currency controlling, interest rate intervention, control of money supply, and others do
not affect the economy.