MACROECONOMICS 2010 Worth Publishers, all rights reserved 2010 Worth Publishers, all rights reservedS E V E N T H E D I T I O NPowerPoint Slides by Ron CronovichN. Gregory MankiwC H A P T E REconomic Growth II:Technology, Empirics, and Policy8Modified for EC 204 by Bob MurphyIn this chapter, you will learn:how to incorporate technological progress in the Solow modelabout policies to promote growthabout growth empirics: confronting the theory with factstwo simple models in which the rate of technological progress is endogenous3CHAPTER 8 Economic Growth IIIntroductionIn the Solow model of Chapter 7, the production technology is held constant.income per capita is constant in the steady state.Neither point is true in the real world:1908-2008: U.S. real GDP per person grew by a factor of 7.8, or 2.05% per year. examples of technological progress abound(see next slide).4CHAPTER 8 Economic Growth IIExamples of technological progressFrom 1950 to 2000, U.S. farm sector productivity nearly tripled. The real price of computer power has fallen an average of 30% per year over the past three decades.Percentage of U.S. households with 1 computers: 8% in 1984, 62% in 2003 1981: 213 computers connected to the Internet2000: 60 million computers connected to the Internet2001: iPod capacity = 5gb, 1000 songs. Not capable of playing episodes of True Blood. 2009: iPod capacity = 120gb, 30,000 songs. Can play episodes of True Blood. 5CHAPTER 8 Economic Growth IITechnological progress in the Solow modelA new variable: E = labor efficiencyAssume: Technological progress is labor-augmenting: it increases labor efficiency at the exogenous rate g: 6CHAPTER 8 Economic Growth IITechnological progress in the Solow modelWe now write the production function as:where L E = the number of effective workers. Increases in labor efficiency have the same effect on output as increases in the labor force. 7CHAPTER 8 Economic Growth IITechnological progress in the Solow modelNotation: y = Y/LE = output per effective worker k = K/LE = capital per effective worker Production function per effective worker:y = f(k)Saving and investment per effective worker:s y = s f(k)8CHAPTER 8 Economic Growth IITechnological progress in the Solow model( + n + g)k = break-even investment: the amount of investment necessary to keep k constant. Consists of: k to replace depreciating capitaln k to provide capital for new workersg k to provide capital for the new “effective” workers created by technological progress9CHAPTER 8 Economic Growth IITechnological progress in the Solow modelInvestment, break-even investmentCapital per worker, k sf(k)( +n +g ) kk* k = s f(k) ( +n +g)k10CHAPTER 8 Economic Growth IISteady-state growth rates in the Solow model with tech. progressn + gY = yEL Total outputg(Y/ L) = yE Output per worker0y = Y/(LE )Output per effective worker0k = K/(LE )Capital per effective worker11CHAPTER 8 Economic Growth IIThe Golden Rule with technological progressTo find the Golden Rule capital stock, express c* in terms of k*:c* = y* i*= f (k* ) ( + n + g) k* c* is maximized when MPK = + n + g or equivalently, MPK = n + g In the Golden Rule steady state, the marginal product of capital net of depreciation equals the pop. growth rate plus the rate of tech progress.12CHAPTER 8 Economic Growth IIGrowth empirics: Balanced growthSolow models steady state exhibits balanced growth - many variables grow at the same rate. Solow model predicts Y/L and K/L grow at the same rate (g), so K/Y should be constant. This is true in the real world. Solow model predicts real wage grows at same rate as Y/L, while real rental price is constant. Also true in the real world. 13CHAPTER 8 Economic Growth IIGrowth empirics: ConvergenceSolow model predicts that, other things equal, “poor” countries (with lower Y/L and K/L) should grow faster than “rich” ones.If true, then the income gap between rich & poor countries would shrink over time, causing living standards to “converge.” In real world, many poor countries do NOT grow faster than rich ones. Does this mean the Solow model fails? 14CHAPTER 8 Economic Growth IIGrowth empirics: ConvergenceSolow model predicts that, other things equal, “poor” countries (with lower Y/L and K/L) should grow faster than “rich” ones.No, because “other things” arent equal. In samples of countries with similar savings & pop. growth rates, income gaps shrink about 2% per year.In larger samples, after controlling for differences in saving, pop. growth, and human capital, incomes converge by about 2% per year. 15CHAPTER 8 Economic Growth IIGrowth empirics: ConvergenceWhat the Solow model really predicts is conditional convergence - countries converge to their own steady states, which are determined by saving, population growth, and education. This prediction comes true in the real world. 16CHAPTER 8 Economic Growth IIGrowth empirics: Factor accumulation vs. production efficiencyDifferences in income per capita among countries can be due to differences in:1. capital physical or human per worker2.the efficiency of production (the height of the production function)Studies: Both factors are important.The two factors are correlated: countries with higher physical or human capital per worker also tend to have higher production efficiency.17CHAPTER 8 Economic Growth IIGrowth empirics: Factor accumulation vs. production efficiencyPossible explanations for the correlation between capital per worker and production efficiency:Production efficiency encourages capital accumulation.Capital accumulation has externalities that raise efficiency.A third, unknown variable causes capital accumulation and efficiency to be higher in some countries than others.18CHAPTER 8 Economic Growth IIGrowth empirics: Production efficiency and free tradeSince Adam Smith, economists have argued that free trade can increase production efficiency and living standards. Research by Sachs & Warner:0.7%4.5%developing nations0.7%2.3%developed nations19CHAPTER 8 Economic Growth IIGrowth empirics: Production efficiency and free tradeTo determine causation, Frankel and Romer exploit geographic differences among countries:Some nations trade less because they are farther from other nations, or landlocked. Such geographical differences are correlated with trade but not with other determinants of income.Hence, they can be used to isolate the impact of trade on income. Findings: increasing trade/GDP by 2% causes GDP per capita to rise 1%, other things equal. 20CHAPTER 8 Economic Growth IIPolicy issuesAre we saving enough? Too much? What policies might change the saving rate? How should we allocate our investment between privately owned physical capital, public infrastructure, and “human capital”?How do a countrys institutions affect production efficiency and capital accumulation? What policies might encourage faster technological progress? 21CHAPTER 8 Economic Growth IIPolicy issues: Evaluating the rate of savingUse the Golden Rule to determine whether the U.S. saving rate and capital stock are too high, too low, or about right. If (MPK ) (n + g ), U.S. is below the Golden Rule steady state and should increase s. If (MPK ) 0.03 = n + g Conclusion: The U.S. is below the Golden Rule steady state: Increasing the U.S. saving rate would increase consumption per capita in the long run. 26CHAPTER 8 Economic Growth IIPolicy issues: How to increase the saving rateReduce the government budget deficit(or increase the budget surplus).Increase incentives for private saving:reduce capital gains tax, corporate income tax, estate tax as they discourage saving.replace federal income tax with a consumption tax.expand tax incentives for IRAs (individual retirement accounts) and other retirement savings accounts.27CHAPTER 8 Economic Growth IIPolicy issues: Allocating the economys investmentIn the Solow model, theres one type of capital. In the real world, there are many types,which we can divide into three categories:private capital stockpublic infrastructurehuman capital: the knowledge and skills that workers acquire through educationHow should we allocate investment among these types? 28CHAPTER 8 Economic Growth IIPolicy issues: Allocating the economys investmentTwo viewpoints:1. Equalize tax treatment of all types of capital in all industries, then let the market allocate investment to the type with the highest marginal product.2. Industrial policy: Govt should actively encourage investment in capital of certain types or in certain industries, because they may have positive externalities that private investors dont consider. 29CHAPTER 8 Economic Growth IIPossible problems with industrial policyThe govt may not have the ability to “pick winners” (choose industries with the highest return to capital or biggest externalities).Politics (e.g., campaign contributions) rather than economics may influence which industries get preferential treatment.30CHAPTER 8 Economic Growth IIPolicy issues: Establishing the right institutionsCreating the right institutions is important for ensuring that resources are allocated to their best use. Examples:Legal institutions, to protect property rights. Capital markets, to help financial capital flow to the best investment projects. A corruption-free government, to promote competition, enforce contracts, etc.31CHAPTER 8 Economic Growth IIPolicy issues: Encouraging tech. progressPatent laws:encourage innovation by granting temporary monopolies to inventors of new products.Tax incentives for R&DGrants to fund basic research at universitiesIndustrial policy: encourages specific industries that are key for rapid tech. progress (subject to the preceding concerns).CASE STUDY: The productivity slowdown1.51.82.62.32.01.61.82.22.48.24.95.74.32.91972-951948-72 U.S. U.K. Japan Italy Germany France CanadaGrowth in output per person(percent per year)33CHAPTER 8 Economic Growth IIPossible explanations for the productivity slowdownMeasurement problems:Productivity increases not fully measured.But: Why would measurement problems be worse after 1972 than before? Oil prices:Oil shocks occurred about when productivity slowdown began.But: Then why didnt productivity speed up when oil prices fell in the mid-1980s?34CHAPTER 8 Economic Growth IIPossible explanations for the productivity slowdownWorker quality:1970s - large influx of new entrants into labor force (baby boomers, women).New workers tend to be less productive than experienced workers. The depletion of ideas:Perhaps the slow growth of 1972-1995 is normal, and the rapid growth during 1948-1972 is the anomaly. 35CHAPTER 8 Economic Growth IIWhich of these suspects is the culprit?All of them are plausible, but its difficult to prove that any one of them is guilty.CASE STUDY: I.T. and the “New Economy”2.02.61.21.21.51.72.21.51.82.62.32.01.61.82.22.48.24.95.74.32.91995-20071972-951948-72 U.S. U.K. Japan Italy Germany France CanadaGrowth in output per person(percent per year)37CHAPTER 8 Economic Growth IICASE STUDY: I.T. and the “New Economy”Apparently, the computer revolution did not affect aggregate productivity until the mid-1990s. Two reasons:1. Computer industrys share of GDP much bigger in late 1990s than earlier. 2. Takes time for firms to determine how to utilize new technology most effectively.The big, open question: How long will I.T. remain an engine of growth? 38CHAPTER 8 Economic Growth IIEndogenous growth theorySolow model:sustained growth in living standards is due to tech progress.the rate of tech progress is exogenous.Endogenous growth theory:a set of models in which the growth rate of productivity and living standards is endogenous.39CHAPTER 8 Economic Growth IIA basic modelProduction function: Y = A Kwhere A is the amount of output for each unit of capital (A is exogenous & constant) Key difference between this model & Solow: MPK is constant here, diminishes in SolowInvestment: s YDepreciation: KEquation of motion for total capital: K = s Y K 40CHAPTER 8 Economic Growth IIA basic model K = s Y K If s A , then income will grow forever, and investment is the “engine of growth.” Here, the permanent growth rate depends on s. In Solow model, it does not. Divide through by K and use Y = A K to get:41CHAPTER 8 Economic Growth IIDoes capital have diminishing returns or not?Depends on definition of “capital.”If “capital” is narrowly defined (only plant & equipment), then yes. Advocates of endogenous growth theory argue that knowledge is a type of capital. If so, then constant returns to capital is more plausible, and this model may be a good description of economic growth. 42CHAPTER 8 Economic Growth IIA two-sector modelTwo sectors:manufacturing firms produce goods.research universities produce knowledge that increases labor efficiency in manufacturing.u = fraction of labor in research (u is exogenous)Mfg prod func: Y = F K, (1-u )E LRes prod func: E = g (u )ECap accumulation: K = s Y K43CHAPTER 8 Economic Growth IIA two-sector modelIn the steady state, mfg output per worker and the standard of living grow at rate E/E = g (u ).Key variables:s: affects the level of income, but not its growth rate (same as in Solow model)u: affects level and growth rate of incomeDISCUSSION QUESTION: The merits of raising “u ”Question:Would an increase in u be unambiguously good for the economy? Why or why not?45CHAPTER 8 Economic Growth IIFacts about R&D1.Much research is done by firms seeking profits.2.Firms profit from research:Patents create a stream of monopoly profits. Extra profit from being first on the market with a new product. 3.Innovation produces externalities that reduce the cost of subsequent innovation.Much of the new endogenous growth theory attempts to incorporate these facts into models to better understand technological progress.46CHAPTER 8 Economic Growth IIIs the private sector doing enough R&D?The existence of positive externalities in the creation of knowledge suggests that the private sector is not doing enough R&D. But, there is much duplication of R&D effort among competing firms. Estimates: Social return to R&D 40% per year. Thus, many believe govt should encourage R&D.47CHAPTER 8 Economic Growth IIEconomic growth as “creative destruction”Schumpeter (1942) coined term “creative destruction” to describe displacements resulting from technological progress:the introduction of a new product is good for consumers, but often bad for incumbent producers, who may be forced out of the market.Examples:Luddites (1811-12) destroyed machines that displaced skilled knitting workers in England.Walmart displaces many “mom and pop” stores.Chapter Summary1.Key results from Solow model with tech progresssteady state growth rate of income per person depends solely on the exogenous rate of tech progressthe U.S. has much less capital than the Golden Rule steady state2.Ways to increase the saving rateincrease public saving (reduce budget deficit)tax incentives for private savingChapter Summary3.Productivity slowdown & “new economy”Early 1970s: productivity growth fell in the U.S. and other countries. Mid 1990s: productivity growth increased, probably because of advances in I.T.4.Empirical studiesSolow model explains balanced growth, conditional convergenceCross-country variation in living standards isdue to differences in cap. accumulation and in production efficiencyChapter Summary5. Endogenous growth theory: Models thatexamine the determinants of the rate of tech. progress, which Solow takes as given.explain decisions that determine the creation of knowledge through R&D.