Chapter 7: Economic Growth I:

Capital Accumulation and Population

Growth

CHAPTER 1 The Science of Macroeconomics 0

 Why growth matters
 Data on infant mortality rates:
 20% in the poorest 1/5 of all countries
 0.4% in the richest 1/5
 In
I Pakistan,
P ki t 85% off peoplel live
li on lless ththan $2/d
$2/day.
 One-fourth of the poorest countries have had
f i
famines d
during
i ththe pastt 3 d
decades.
d
 Poverty is associated with oppression of women
and minorities.
minorities
Economic growth raises living standards and
reduces poverty
poverty….
CHAPTER 7 Economic Growth I 1
 Income and poverty in the world
selected countries, 2000
100
Madagascar
90
India
ay or less

80 Nepal
Bangladesh
of populattion

70
n $2 per da

60 Kenya Botswana

50 China
%o

40 Peru
living on

Mexico
30 Thailand
20
Brazil Chile
10 Russian
Federation S. Korea
0
$0 $5 000
$5,000 $10 000
$10,000 $15 000
$15,000 $20 000
$20,000
Income per capita in dollars
links to prepared graphs @ Gapminder.org
notes: circle size is proportional to population size,
color of circle indicates continent, press “play” on
bottom to see the cross section graph evolve over time
time,
click here for one-page instruction guide
Income per capita and
 Life expectancy
 Infant mortality
 Malaria deaths per 100,000
 Adult literacy
 Cell phone users per 100,000
 Why growth matters

 Anything
y g that effects the long-run
g 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 of
g standard of living after
after…
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%

,

CHAPTER 7 Economic Growth I 4

 Why growth matters
 If the annual growth rate of U.S. real GDP per
capita had been just one
one-tenth
tenth of one percent
higher during the 1990s, the U.S. would have
generated an additional $496 billion of income
during that decade.

CHAPTER 7 Economic Growth I 5

 The lessons of growth theory
…can make a positive difference in the lives of
hundreds of millions of people.
p p
These lessons help us
 understand why poor
countries are poor
 design policies that
can help them grow
 learn how our own
growth
th rate
t is
i affected
ff t d
by shocks and our
government’s
government s policies

CHAPTER 7 Economic Growth I 6

 The Solow model
 due to Robert Solow,
won Nobel Prize for contributions to
the study of economic growth
 a major
j paradigm:
di
 widely used in policy making
 benchmark against which most
recent growth theories are compared
 looks at the determinants of economic growth
and the standard of living in the long run

CHAPTER 7 Economic Growth I 7

 How Solow model is different from
Ch t 3’
Chapter 3’s model
d l
1. K is no longer fixed:
investment causes it to grow,
depreciation causes it to shrink
2. L is no longer fixed:
population growth causes it to grow
3. the consumption function is simpler

CHAPTER 7 Economic Growth I 8

 How Solow model is different from
Ch t 3’
Chapter 3’s model
d l
4. no G or T
(only to simplify presentation;
we can still do fiscal policy experiments)
5. cosmetic differences

CHAPTER 7 Economic Growth I 9

 The production function
 In aggregate terms: Y = F (K, L)
 Define: y = Y/L = output per worker
k = K/L = capital per worker
 Assume constant returns to scale:
zY = F (zK, zL ) for any z > 0
 Pick z = 1/L. Then
Y/L = F ((K/L, 1))
y = F (k, 1)
y = f(k) where f(k) = F(k, 1)

CHAPTER 7 Economic Growth I 10

 The production function
Output per
worker,
o e,y
f(k)

MPK = f(k +1) – f(k)

1

Note: this production function

exhibits diminishing MPK.

Capital
p p
per
worker, k
CHAPTER 7 Economic Growth I 11
 The national income identity
 Y=C+I (remember, no G )
 In “per worker” terms:
y=c+i
where
h d i = I /L
c = C/L and

CHAPTER 7 Economic Growth I 12

 The consumption function

 s = the saving rate,

the fraction of income that is saved
(s is an exogenous parameter)
Note: s is the only lowercase variable that
is not equal to
its uppercase version divided by L

 Consumption function: c = (1
(1–s)y
s)y
(per worker)

CHAPTER 7 Economic Growth I 13

 Saving and investment

 saving (per worker) = y – c

= y – (1–s)y
= sy
 National income identity is y = c + i
Rearrange to get: i = y – c = sy
(investment = saving, like in chap. 3!)

 Using the results above,

i = sy = sf(k)

CHAPTER 7 Economic Growth I 14

 Output, consumption, and investment
Output per f(k)
worker y
worker,

c1
y1 sf(k)

i1

k1 Capital per
worker, k
CHAPTER 7 Economic Growth I 15
 Depreciation
Depreciation  = the rate of depreciation
worker k
per worker, = the fraction of the capital stock
that wears out each period

k


1

Capital per
worker, k
CHAPTER 7 Economic Growth I 16
 Capital accumulation

The basic idea: Investment increases the capital

stock, depreciation reduces it.

Change in capital stock = investment – depreciation

k = i – k

Since i = sf(k) , this becomes:

k = s f(k) – k

CHAPTER 7 Economic Growth I 17

 The equation of motion for k

( ) – k
k = s f(k)
 The Solow model’s central equation
 Determines
D t i b
behavior
h i off capital
it l over titime…
 …which, in turn, determines behavior of
all of the other endogenous variables
because they all depend on k. E.g.,
income per person: y = f(k)
consumption per person: c = (1–s) f(k)

CHAPTER 7 Economic Growth I 18

 The steady state

( ) – k
k = s f(k)
If investment is just enough to cover depreciation
[sf(k) = k ],
]
then capital per worker will remain constant:
k = 00.

This occurs at one value of k,, denoted k*,

called the steady state capital stock.

CHAPTER 7 Economic Growth I 19

 The steady state

Investment
and k
depreciation
sf(k)

k* Capital per
worker, k
CHAPTER 7 Economic Growth I 20
 Moving toward the steady state
k = sf(k)  k
Investment
and k
depreciation
sf(k)

k
investment

d
depreciation
i ti

k1 k* Capital per
worker, k
CHAPTER 7 Economic Growth I 21
 Moving toward the steady state
k = sf(k)  k
Investment
and k
depreciation
sf(k)

k

k1 k2 k* Capital per
worker, k
CHAPTER 7 Economic Growth I 22
 Moving toward the steady state
k = sf(k)  k
Investment
and k
depreciation
sf(k)

k
investment
depreciation

k2 k* Capital per
worker, k
CHAPTER 7 Economic Growth I 23
 Moving toward the steady state
k = sf(k)  k
Investment
and k
depreciation
sf(k)

k

k2 k* Capital per
worker, k
CHAPTER 7 Economic Growth I 24
 Moving toward the steady state
k = sf(k)  k
Investment
and k
depreciation
sf(k)

k

k2 k3 k* Capital per
worker, k
CHAPTER 7 Economic Growth I 25
 Moving toward the steady state
k = sf(k)  k
Investment
and k
depreciation

S
Summary: sf(k)
As long as k < k*,
investment will exceed
depreciation,
and k will continue to
grow toward k*.

k3 k* Capital per
worker, k
CHAPTER 7 Economic Growth I 26
NOW YOU TRY:
Approaching k* from above
Draw the Solow model diagram
diagram,
labeling the steady state k*.
On the
O th horizontal
h i t l axis,
i pick
i k a value
l greater than k*
t th
for the economy’s initial capital stock. Label it k1.
Show what happens to k over time.
Does k move toward the steady state or
away from it?
 A numerical example
Production function (aggregate):
Y  F (K , L )  K  L  K 1 / 2L1 / 2

To derive
T d i th the per-worker
k production
d ti ffunction,
ti
divide through by L:
1/2
Y K L 1/2 1/2
K 
  
L L L 

Then substitute y = Y/L and k = K/L to get

y  f (k )  k 1 / 2
CHAPTER 7 Economic Growth I 28
 A numerical example, cont.

Assume:
 s = 0.3
  = 0.1
01
 initial value of k = 4.0

CHAPTER 7 Economic Growth I 29

 Approaching the steady state:
A numerical example
Assumptions: y  k ; s  0.3;   0.1; initial k  4.0
Year k y c i k Dk
1 4.000 2.000 1.400 0.600 0.400 0.200
2 4 200
4.200 2 049
2.049 1 435
1.435 0 615
0.615 0 420
0.420 0 195
0.195
3 4.395 2.096 1.467 0.629 0.440 0.189
4 4 584
4.584 2 141
2.141 1 499
1.499 0 642
0.642 0 458
0.458 0 184
0.184
…
10 5.602 2.367 1.657 0.710 0.560 0.150
…
25 7.351 2.706 1.894 0.812 0.732 0.080
…
100 8 962
8.962 2 994
2.994 2 096
2.096 0 898
0.898 0 896
0.896 0 002
0.002
…

CHAPTER 7 9.000
Economic 3.000 I 2.100
Growth 0.900 0.900 0.000 30
NOW YOU TRY:
Solve for the Steady State

Continue to assume
s = 0.3,  = 0.1, and y = k 1/2

Use the equation of motion

( )  k
k = s f(k)
to solve for the steady-state values of k, y, and c.
ANSWERS:
Solve for the Steady State
k  0 def. of steady state
s f (k *)   k * eq'n of motion with k  0

0.3 k *  0.1k * using assumed values

k*
3  k*
k*
Solve to get: k *  9 and y *  k *  3

Finally c *  (1  s )y *  0.7
Finally, 0 7  3  2.1
21
 An increase in the saving rate
An increase in the saving rate raises investment…
…causingg k to g
grow toward a new steady y state:

Investment
and dk
depreciation s2 f(k)

s1 f(k)

k
k 1* k 2*
CHAPTER 7 Economic Growth I 33
 Prediction:

 Higher
g s  higher
g k*.

 And since y = f(k) ,

hi h k*  higher
higher hi h y* .

 Thus,
Thus the Solow model predicts that countries
with higher rates of saving and investment
will have higher levels of capital and income per
worker in the long run.

CHAPTER 7 Economic Growth I 34

 International evidence on investment rates
and income per person
Income per 100,000
person in
2003
(log scale)
10,000
,

1,000

100
0 5 10 15 20 25 30 35
Investment as percentage of output
(average 1960-2003)
 The Golden Rule: Introduction

 Different values of s lead to different steady states.

H
How d
do we kknow which
hi h iis th
the “b
“best”
t” steady
t d state?
t t ?
 The “best” steady state has the highest possible
consumption
ti per person: c** = (1–s)
(1 ) f(k*)
f(k*).
 An increase in s
 leads to higher k* and y*, which raises c*
 reduces consumption’s share of income (1–s),
which
hi h llowers c*.
*
 So, how do we find the s and k* that maximize c*?

CHAPTER 7 Economic Growth I 36

 The Golden Rule capital stock

k gold
*
 the Golden Rule level of capital,
p ,
the steady state value of k
that maximizes consumption.
To find it, first express c* in terms of k*:
c* = y*  i*
= f (k*)  i*
In the steady state:
= f (k*)   k* i* = k*
because k = 0.

CHAPTER 7 Economic Growth I 37

 The Golden Rule capital stock
steady state
output and
depreciation k
k*
Then, graph
f(k*) and k*,
f(k
( *)
look for the
point where
p
the gap between c gold
*

them is biggest.
i gold
*
  k gold
*

y gold
*
 f (k gold
*
) k gold
*
steady-state
capital per
worker, k*
CHAPTER 7 Economic Growth I 38
 The Golden Rule capital stock

c* = f(k*)  k* k
k*
is biggest where the
slope of the f(k
( *)
production function
equals
the slope of the
depreciation line: c gold
*

MPK = 
k gold
*
steady-state
capital per
worker, k*
CHAPTER 7 Economic Growth I 39
 The transition to the
Golde Rule
Golden R le steady
te d state
t te
 The economyy does NOT have a tendencyy to
move toward the Golden Rule steady state.
 Achieving the Golden Rule requires that
policymakers adjust s.
 This adjustment leads to a new steady state with
higher consumption.
 But what happens to consumption
during the transition to the Golden Rule?

CHAPTER 7 Economic Growth I 40

 Starting with too much capital

If k *  k gold
*

then increasing c* y
requires
q a fall in s.
In the transition to c
the Golden Rule,,
consumption is i
higher at all points
in time.
t0 time

CHAPTER 7 Economic Growth I 41

 Starting with too little capital

If k *  k gold
*

th iincreasing
then i c*
requires an y
increase in s.
c
Future generations
j y higher
enjoy g
consumption,
but the current i
one experiences
i
an initial drop t0 time
p
in consumption.

CHAPTER 7 Economic Growth I 42

 Population growth
 Assume the population and labor force grow
at rate n (exogenous):
L
 n
L
 EX: Suppose L = 1,000 in year 1 and the
population
l ti iis growing
i att 2% per year ((n = 0.02).
0 02)
 Then L = n L = 0.02  1,000 = 20,
so L = 1,020 in year 2.

CHAPTER 7 Economic Growth I 43

 Break-even investment

 ( + n)k = break-even investment,

the amount of investment necessary
to keep k constant.
 Break-even investment includes:
  k to replace capital as it wears out
 n k to equip new workers with capital
(Otherwise, k would fall as the existing capital stock
(Otherwise
is spread more thinly over a larger population of
workers.)

CHAPTER 7 Economic Growth I 44

 The equation of motion for k

 With population growth,

the equation of motion for k is:

k = s f(k)  ( + n) k

actual
break-even
b k
investment
investment

CHAPTER 7 Economic Growth I 45

 The Solow model diagram

Investment,
k = s f(k)  ( +n)k
break even
break-even
investment
( + n ) k

sf(k)

k* Capital per
worker, k
CHAPTER 7 Economic Growth I 46
 The impact of population growth

Investment,
break even
break-even ( +n2) k
investment
( +n1) k
An increase in n
causes an sf(k)
increase in break-
even investment,
i t t
leading to a lower
steady-state
y level
of k.

k2* k1* Capital per

worker, k
CHAPTER 7 Economic Growth I 47
 Prediction:
 Higher n  lower k*.
 And since y = f(k) ,
lower k*  lower y*.

 Thus, the Solow model predicts that countries

with higher population growth rates will have
lower levels of capital and income per worker in
the long run
run.

CHAPTER 7 Economic Growth I 48

 International evidence on population growth
and income per person
Income per 100,000
person in
2003
(log scale)
10,000

1,000

100
0 1 2 3 4 5
Population growth
(percent per year, average 1960-2003)
 The Golden Rule with population
growth
To find the Golden Rule capital stock,
express c* in terms of k*:
c* = y*  i*
= f (k* )  ( + n) k*
In the Golden
c* is
i maximized
i i d when
h R l steady
Rule t d state,
t t
MPK =  + n the marginal product
of capital net of
or equivalently, depreciation equals
MPK   = n the p
population
p
growth rate.
CHAPTER 7 Economic Growth I 50
 Alternative perspectives on population
growth
The Malthusian Model (1798)
 Predicts population growth will outstrip the
Earth’s ability to produce food, leading to the
impoverishment of humanity
humanity.
 Since Malthus, world population has increased
sixfold yet living standards are higher than ever
sixfold, ever.
 Malthus neglected the effects of technological
p g
progress.

CHAPTER 7 Economic Growth I 51

 Alternative perspectives on population
growth
The Kremerian Model (1993)
 Posits that population growth contributes to
economic growth.
 More people = more geniuses, scientists &
engineers, so faster technological progress.
 Evidence,
E id ffrom very long
l hi
historical
t i l periods:
i d
 As world pop. growth rate increased, so did rate
of growth in living standards
 Historically, regions with larger populations have
enjoyed faster growth
growth.
CHAPTER 7 Economic Growth I 52
 Chapter Summary
1. The Solow growth model shows that,
iin the
th long
l run, a country’s
t ’ standard
t d d off liliving
i
depends:
 positively
iti l on itits saving
i rate
t
 negatively on its population growth rate
2. An increase in the saving rate leads to:
 higher output in the long run
 faster growth temporarily
 but not faster steady state growth
 Chapter Summary
3. If the economy has more capital than the
Golden
G ld R Rule
l llevel,
l th
then reducing
d i savingi willill
increase consumption at all points in time,
making all generations better off
off.
If the economy has less capital than the
G ld R
Golden Rule
l llevel,
l th
then iincreasing
i saving
i will
ill
increase consumption for future generations,
but reduce consumption for the present
generation.