Macro Introduction Refresher

Benjamin Wache

VU Amsterdam & Tinbergen Institute

28 August 2019
Overview

I Instructor Benjamin Wache, PhD Student in Economics at VU

I You can reach me at this e-mail address: b.wache@vu.nl
I The aim of this session is to make sure that all of you have the
tools to follow successfully your classes in the master programs
I This session is a part of a refresher in Macroeconomics and
will focus on Growth Theory
I We will go through the theory and the empirics of the Solow
model (basic growth theory model)
I This is the first part of two independent sessions. This one
covers long run economy dynamics. The second one, on Real
Business Cycle, will cover short and medium run dynamics.
Motivation
How do we go from this?

Figure 1: Shenzen, 1980

To this

Figure 2: Shenzen, 2011

Introdution to Solow growth model

Solow model (1956), known as the neoclassical growth model, is

the canonical dynamic general equilibrium model used to analyze
the growth dynamics of an economy.

Key aspects:
I Very stylized
I Capital accumulation and technology are the main drivers for
macroeconomic growth
I Constant savings rate
Structure of the model

I Households decide how much of their income to consume and

save, how much labor to supply
I Firms invest and produce with a given production function
and technology
I Real wages and real returns to capital are the prices in the
economy
I Savings and investment imply dynamics
Solution of the model

To solve the model we need:

I preferences of households
I production functions of the firms
I market structure for labour and goods markets
I define an equilibrium
I static if it is in a given point
I dynamic if it is over time
Household preferences

Very simple agents in this models:

I inelastically supply L(t) units of labour
I save a fixed share s of their income
Production function

I Aggregate production function at time t:

Y (t) = F (K (t), A(t)L(t))

where,

I Y(t) is aggregate output which can be consumed and

saved/invested
I K(t) is physical capital (machine tools, motor vehicles,
computer hardware and software)
I L(t) is labour
I A(t) is effectiveness of labour or knowledge
I A(t)L(t) is a labour-augmenting technology
Production function

I A(t) is what we generally call technology

I it means that over the course of time, people have
accumulated more and more ideas that allow them to get
more output using the same inputs (in terms of K and L)
I higher A(t) means higher efficiency
I A(t) is generally assumed to accumulate/grow over time
(think R&D, knowledge spillovers, specialization)
Production function

Two crucial assumptions for the production function:

1 it shows Constant Returns to Scale (CRS) in K (t) and
A(t)L(t):

F (λK (t), λA(t)L(t)) = λF (K (t), A(t)L(t))

for every λ > 0

I this means that if we double the inputs used, this will exactly
double the output produced (”can always replicate what’s
already there”)

2 other factors (e.g., land, human capital) are ignored (for now)
Production function

Making use of the CRS property we can express all variables in

effective labour units (divided by A(t)L(t)). It will be helpful later.
1 K (t)
We define A(t)L(t) = λ (for CRS) and A(t)L(t) = k(t).

Y (t)
y (t) =
A(t)L(t)
F (K (t), A(t)L(t))
y (t) =
A(t)L(t)
K (t)

y (t) = F ,1
A(t)L(t)
y (t) = F (k(t), 1)
y (t) = f (k(t)) (1)
Production function

The intensive-form production function is assumed to satisfy the

following conditions:
1 f(0)=0
2 f’()>0
3 f”()<0
Output increases as far as capital in intensive form increases, but
decreasingly so.
Production function

Figure 3: Example of standard production function

Marginal product of capital

I Marginal product of capital (MPK) informs us about how

much the output grows due to a marginal increment of capital.
I Analytically the first derivative of the production function with
respect to K (t)
∂F (K (t),A(t)L(t))
I
∂K (t) = f 0 (k(t))
Marginal product of labour

I Marginal product of labour (MPL) informs us about how

much the output grows due to a marginal increment of labour.
I Analytically the first derivative of the production function with
respect to L(t)
∂F (K (t),A(t)L(t))
I
∂L(t) = MPL
Example

We can work together on this example. Let’s consider a

Cobb-Douglas production function:

F (K (t), A(t)L(t)) = K (t)α (A(t)L(t))1−α

where 0 < α < 1

I check if it satisfies CRS assumption
I write it in intensive form
I derive MPK and MPL
Example

CRS assumption...

F (λK (t), λA(t)L(t)) = (λK (t))α (λA(t)L(t))1−α

F (λK (t), λA(t)L(t)) = λα K (t)α λ1−α A(t)L(t)1−α

F (λK (t), λA(t)L(t)) = λK (t)α A(t)L(t)1−α
F (λK (t), λA(t)L(t)) = λF (K (t), A(t)L(t))
holds
Example

To write a Cobb-Douglas function in intensive form, we have to

divide the function by A(t)L(t).

F (K (t), A(t)L(t)) = K (t)α (A(t)L(t))1−α

F (K (t), A(t)L(t))
= K (t)α (A(t)L(t))−α
A(t)L(t)
!α
K (t)
F (k(t), 1) =
A(t)L(t)
f (k(t)) = k(t)α
Example

I f (0) = 0α = 0
I f 0 (k(t)) = αk(t)α−1 > 0
I f 00 (k(t)) = α(α − 1)k(t)α−2 < 0
Example

I MPK = αk(t)α−1
I MPL = (1 − α)Ak(t)α
MPL can be rewritten:

A[k(t)α − αk(t)α ]

Recalling that f 0 (k(t)) = αk(t)α−1 and y (t) = k(t)α , we can

write that:
MPL = A[y (t) − f 0 (k(t))k(t)]
Market structure

I All three markets are perfectly competitive

I =⇒ wages and rental cost of capital are equal to marginal
product of labour and capital
I capital and labour are supplied inelastically
Dynamics of the model

I The Solow Growth model is a dynamic model. It makes

predicitions about the paths of variables over time
I Considering the variable X , its change in (time) ∆ is:

X (t) − X (t − ∆)
∆
I if ∆ approaches 0, the change of X over time becomes:

∂X (t)
Ẋ (t) =
∂t
I We can now write a continuous time version of the growth
rate at time t as:
Ẋ (t)
g=
X (t)
Dynamics of the model

I Note that taking the time derivative of ln X(t) will also give
the growth rate:

∂lnX (t) 1 ∂X (t) 1

= = Ẋ (t)
∂t X (t) ∂t X (t)
I Growth rate of the product of two variables: Z(t)=X(t)Y(t)

∂lnZ (t) ∂lnX (t) ∂lnY (t)

= +
∂t ∂t ∂t

Ż (t) Ẋ (t) Ẏ (t)

= +
Z (t) X (t) Y (t)
Evolution of labour and technology

I Given the initial values of A(0), L(0) and K (0) (all > 0),
assume that labour and technology will exhibit constant
growth rates (implying exponential growth)
I A(t) = A(0)e gt
I L(t) = L(0)e nt
I If we take logs and then differentiate with respect to time we
will obtain:
Ȧ(t)
=g
A(t)
L̇(t)
=n
L(t)
Savings and Investment

I Output Y (t) is used for consumption and investment

I Households have constant savings rate s (and hence constant
consumption rate (1 − s))
I Savings are used to create additional capital and replace
depreciated capital (depreciation at rate δ)
Dynamics of capital stock

I The pre-period change in K(t) is therefore the amount of

income saved net of depreciation:

K̇ (t) = sY (t) − δK (t)

Closing the model

Given laws of motion of K(t), L(t), A(t), properties of production

function, and parameters, the model description is complete
I no government
I no fluctuations
I s is constant
I δ is constant
I n and g are constant
I aggregate production function with 3 inputs
Solving for equilibrium

I Thus far we have assumed that the economy is in equilibrium

at every point in time, as households and firms behave as
rational utility/profit maximizers, and markets for inputs and
final goods clear: static equilibrium
I We have to determine the equilibrium path of the economy
over time
I The one crucial input whose path is not taken as given is the
capital stock, K (t)
I Therefore, to solve for the dynamic equilibrium, we must solve
for the path of K (t), so that the path of the economy is
well-defined and there is no reason to deviate from it over
time: a stable growth path
I Intuitively, to make sure that the economy has sufficient
capital to produce given the growth of labor and technology
each period, capital will also have to grow
I Therefore, to solve the equilibrium, we will work using capital
per effective worker, k(t)
Dynamics of k

We can derive the path of k(t) applying the chain rule with respect
K (t)
time to k(t) = A(t)L(t)

K̇ (t) K (t)
k̇(t) = − [Ȧ(t)L(t) + A(t)L̇(t)]
A(t)L(t) [A(t)L(t)]2

K̇ (t) K (t) Ȧ(t) K (t) L̇(t)

k̇(t) = − −
A(t)L(t) [A(t)L(t)] A(t) [A(t)L(t)] L(t)
sY (t) − δK (t)
k̇(t) = − k(t)g − k(t)n
A(t)L(t)
k̇(t) = sy (t) − δk(t) − k(t)g − k(t)n = sf (k(t)) − (n + g + δ)k(t)
This is the key equation of the model!
Dynamics of k

I Savings will be used in order to increase capital taking into

account potential new workers (n), technological improvement
(g ) and depreciation of already existing capital δ.
I Under what conditions is actual investment sufficient to keep
up with need for capital resulting from n, g , and δ?
I Break even condition:

k̇(t) = 0 ⇐⇒ sf (k(t)) = (n + g + δ)k(t) (2)

Dynamics of k

Figure 4: Savings-Investment diagram

Dynamics of k

Three possibilities:
I k(t) grows because there are more savings than investment
needed to keep k constant if

sf (k(t)) > (n + g + δ)k(t)

I k(t) shrinks because there are not enough savings than

investment needed to keep k constant if

sf (k(t)) < (n + g + δ)k(t)

I k(t) is constant if break even condition (2) holds

Dynamics of k

Figure 5: Break even condition

Dynamics of k

Figure 6: Balanced growth path

Balanced growth path

We will try to see what is the growth rate of the main variables
when k(t) is constant or when economy is on balanced growth
path.
I Given that K (t) = k(t)A(t)L(t) and k(t) is constant, capital
grows in steady state at the rate n + g
K (t)
L(t) which is capital per worker grows at rate g
I

Y (t)
L(t) which is output per worker grows at rate g
I

I in steady state, the only driver for economic growth is

technology (A)
Balanced growth path in US

Figure 7: Balanced growth path in US

Change in savings rate

Figure 8: Increase in savings rate

Impact on variables

K (t)
I We can clearly see that k ∗ and y ∗ increase. Therefore, L(t)
Y (t)
and L(t) increase too.
I We cannot say anything about changes of consumption per
worker:
c ∗ = f (k ∗ ) − (n + g + δ)k ∗
∂c ∗ ∂k ∗
= [f 0 (k ∗ ) − (n + g + δ)]
∂s ∂s
∗
Remember that k is an increasing function of s. The result
depends on the relation between f 0 (k ∗ ) and n + g + δ
Transition

Figure 9: Jump
Transition

Figure 10: Adjustment

Solow model and reality

We will try to figure out whether Solow model is able to explain

some patterns we can see in reality. The analysis is focused on two
decisive aspects of the model: capital per worker and technology.
Capital per worker

Researchers have tried to test if the capital per worker values (with
both a time series approach and across countries analysis)
predicted by the model match with the income distribution
I Over time: model implies that the capital-to-worker ratio is
approximately 10 times larger today than 100 years ago for
industrialized countries. Capital-to-output ratios are
approximately constant
I Across countries: model implies that the the capital-to-worker
ratio is approximately 20 to 30 times larger in industrial
countries, not 100. Capital-to-output ratios are approximately
2 to 3 times larger in industrial countries than in developing
countries
I observed K/L ratio differences are too small to account for
observed differences in income
Returns to capital
Obtaining consistent measures of variables, such as capital, over
time and across countries can be tricky. An alternative approach is
to look at its price (or return), which in theory should be less prone
to measurement error. Large differences in capital per worker
should then also imply huge difference in capital’s rate of return.
I If markets are competitive, the rate of return to capital should
equal its marginal product, f0 (k), less the depreciation rate, δ
α−1
I f0 (k)=αy α

I Again, we can consider a capital share value of one third,

which implies that a tenfold difference in income per worker,
say, would imply a hundredfold difference in the MPK,
implying an even larger difference in the rates of return, f0 (k)
−δ
I Empirical evidence does not find such dramatic differences in
financial returns, either over time nor across countries, in
order to explain the observed income differences
Lucas Puzzle

I In a famous paper, Lucas (1990) observes that according to

the Solow model, lower income (i.e. low capital stock)
countries should have much higher MPKs, thus higher rates of
return.
I Capital should therefore flow from rich to poor countries!
I But in reality we do not observe this (rather the opposite):
The Lucas Puzzle
Lucas puzzle

What might explain the Lucas Puzzle?

I The Solow model ignores many imperfections, such as
expropriation risk, capital market imperfection
I Turn to differences in effectiveness of labor in order to explain
income differences in the Solow model
Effectiveness of labour

A is an exogenous variable in the model. A is treated as a

“catchall” for all other possible factors, other than capital and
labor, in the model, such as:
I Knowledge: why differs across countries? Why not
transmitted?
I Education/skill: generally “human capital”
I Institutional quality: property rights, corruption
I Quality of infrastructure
So What?

To explain income differences then, consider different possibilities:

I Capital is more important for growth than the Solow model
implies
I Other factors, currently captures in A, are the main source of
growth over time and income differences
References

This session is very close to First chapter of Advanced

Macroeconomics by David Romer (textbook used in Advanced
Macro course).
Question???

Thank you for your attention.

See you tomorrow or good luck with your Master :)