Norton Media Library: The Facts of Economic Growth
Norton Media Library: The Facts of Economic Growth
Norton Media Library: The Facts of Economic Growth
Chapter 1
Introduction:
The Facts of
Economic
Growth
Charles I. Jones
• There is tremendous variation in
performance across countries of the world
Rule of 70:
If Y grows at g percent per year, then:
The level of Y Doubles every 70/g years
• t
Table 1.1
• The world income distribution is highly
skewed
– About 2/3 of the world population has at most
20% of the GDP per worker of the US
– About 1/10 of the world population at least
80% of the GDP per worker of the US
• The world income distribution is changing over
time
– The bulk of the world’s population is substantially
richer today than it was in 1960.
– The fraction of people living in poverty has fallen
since 1960.
– A major reason for these changes is the recent
economic growth in China and India
• which together account for 40 percent of the world
population.
• In addition to the level of income rising
over time, the growth rate of world income
has also been rising over time
Chapter 2
The Solow Model
Charles I. Jones
The Production Function
• A production function describes the way we can
use inputs to produce outputs
– technically speaking, a production function tells us the
maximum amount of output we can produce for every
combination of inputs
OR (α-1)•α•A•kα-2
• Since A, k and α are positive numbers, the only way for
marginal product to be diminishing is if
(α-1) < 0
Which means α < 1
• Graphing the Cobb-Douglas function
The Basic Solow Model
• Solow won the Noble Prize primarily for
his contributions to Growth Theory
• His model is the foundation of all modern
growth theories
• The simplified Solow model
• Accumulation of physical capital, K, is an
important feature in this model
– Capital is built by investing in capital goods.
– Each dollar of investment, I, builds an additional dollar
of capital. This means the capital stock will increase.
This suggests
ΔK=I
Where ΔK is the change in the capital stock
• Capital increases if we invest
– This simple equation implies the capital stock will
never fall since I can never be negative. But that
implication is not true empirically.
– What is missing is the fact that capital depreciates and
that a lot of investment is done to replenish depreciated
capital. Let D=depreciated capital, and the equation
becomes:
ΔK=I-D
• Capital depreciates by
– wearing out from use or age
– becoming technologically obsolete (i.e. out of date)
• Since we model variables in per capita terms to
compare across countries, divide all variables in
the equation by L
K I D
L L L
• Redefine variables so that lower case letters denote
per capita values:
Δk=i-d
• For now assume that L is fixed – not growing
• Assume that investment is a fixed share of
income: =i/y noting that I/Y=i/y and
that 0 < < 1
• Assume that capital depreciates at a constant rate:
d=δk
• (from D= δK and then dividing by L )
• Assume a general form for a production function:
y=A•f(k)
• Putting all of these assumptions into the equation for
capital accumulation ( Δk=i-d )
We obtain: k A f (k) k
• This equation tells us how the capital stock k is
determined given specific values of , A, δ and
parameters in the production function (e.g. α in a
Cobb-Douglas production function).
• It is convenient to analyze this model graphically (To
make my equation line up with the following graph let
A in the equation be 1, but this is only temporary – it
will be very important to allow for changes in A)
• The graph plots three equations
k ss A
k ss
1 A
k ss
1/(1 )
A
k ss
• Then we can solve for yss: : yss A k ss
A 1/(1 )
y ss A
/(1 )
A
yss A
/(1 ) /(1 )
(1 )/(1 ) /(1 ) 1/(1 )
yss A A A
• Our final result is: /(1 )
1/(1 )
yss A
• Suppose we have two countries, Country i and
Country j. Each will have its own steady state, yi
and yj and the ratio of the steady states is:
i /(1i )
i
1/(1i )
A i
yi i
j /(1 j )
yj 1/(1 j ) j
Aj
j
• The previous equation allow each country to
potentially have a unique value α, δ, A or
• Suppose the investment share is the only thing that
differs across countries.
– Then Ai=Aj, αi=αj and δi=δj,
• And our general result simplifies as follows:
i /(1i )
1/(1i ) i
A /(1 )
yi
i
i i
yj j
j /(1 j )
1/(1 j ) j
A
j j
• Measures are available for
– The investment share for every country, and
– The parameter α
• Economic theory tells us that α is equal to the share of income
that goes to capital, which we estimate as roughly equal to 1/3
1/ 3 1
• So if α=1/3,
1 2 / 3 2
– Thus the model predicts the ratio of incomes per capita
will equal: 1/ 2
yi i
yj
j
• Numerical examples
– If i .2 (20%) and j .05 (5%)
yi
4
1/ 2
then 2
yj
– If i .32 (32%) and j .02 (2%)
yi
16
1/ 2
then 4
yj
– The ratio of income between richest and poorest countries
is more that 50 today
• This evidence suggests that cross-country variation in investment
rates will not be sufficient to make the Solow model explain cross-
country differences in income per capita
• Lets look at a broad selection of countries to see
how well or poorly the model performs
• We use a graph and a large cross section of
countries that plots
I Spvt +Sgovt CA
= -
Y Y Y
OR I Spvt Sgovt CA
= -
Y Y Y Y
k A f (k) k
• We know that by dividing both sides of this
equation by k we get an expression for the growth
rate of k
k
k̂ A f (k) / k
k
• Suppose that the investment rate and the depreciation rate are
equal to zero. In that case the last equation says that k grows at
the rate zero. If k growth is zero then k is at some constant
value.
• Recall an even earlier equation: ΔK=I-D
– If the investment rate = 0, investment = 0
– If the depreciation rate = 0, depreciation = 0
– Thus ΔK=0, which means K grows at a rate of zero (divide both side of
the equation by K, to get ΔK/K
• Here’s the problem: k=K/L
– If K is NOT growing while L is growing then k must be shrinking ---- it
can NOT reach a positive steady state level
• We need to fix our Δk/k equation
• The fix is simple and intuitive: If δ and are zero then K must
also be zero. And, if L grows at a constant rate, n, k will be
shrinking at that rate, that is k will grow at the rate –n
• This suggests that the fix obtains by subtracting the population
growth rate from the right side of the previous growth rate of k
equation
We change the capital accumulation
equation in specific ways
• It is convenient to change capital accumulation from a
difference equation to a differential equation (this
means changing from discrete time to continuous time
model)
• From calculus we know that:
K dK
as t 0, lim
t dt
• Dividing by some finite number doesn’t change that,
so: 1 K 1 dK
as t 0, lim
K t K dt
• Thus our original capital accumulation equation
becomes:
dK
F(A, K, L) K
dt
• We, also, will modify our Cobb Douglas production
function to have labor augmenting productivity
1
F(A, K, L) K (AL)
• Labor augmenting means that in the production
function A multiples L.
• AL is sometimes called “effective labor input”.
– It adjusts labor effort by the productivity of labor
Putting this all together yields our
new capital accumulation equation
•
dK 1
K (AL) K
dt
• But we want to put things in terms of output per capita and
given constant returns to K and L that means when the
production function is divided by L that will make of output
per capita a function of productivity and capital per capita.
• Thus we would like to put our capital accumulation equation
in terms of capital per capita.
We will assume for convenience:
Population (or the work force) grows
at a constant rate
1 dL
n
L dt
• Where n is a constant equal to the growth rate
• This is a differential equation that is easy to solve (if
you know something about differential equations)
• The solution is: L(t)=Loent
• This is the equation for the level of L if it grows at a
constant rate
How are capital growth and capital
per capita growth related?
• First, recall that k = K/L
• We can take the logarithm of the last equation
log(k) log(K) log(L)
• Then take time derivative of this equation
d d d
log(k) log(K) log(L)
dt dt dt
• And finally obtain
1 dk 1 dK 1 dL
k dt K dt L dt
• Thus, we can take the production capital accumulation equation from before
divide by K, and use the last equation plus the assumption that labor grows at a
constant rate to get:
1 dk 1
k dt
K
K
(AL)1
K n
• Or simplifying we obtain:
Y K
• Define y
% and k%
AL AL
%
yk
%
• Then the production function becomes
• these transformed variables are defined as:
&
• For any variable Z, define: Z
dZ
dt
& dK
• That means: K
dt
• Using this definition in the capital accumulation
equation &
K Y K
• Then dividing by K yields: &
K Y
K K
Y
Y AL %
y %1
• Note that k
K K %
k
AL
• And so we obtain:
&
K %1
k
K
• We need an expression for the growth rate of capital in
terms of capital per effective labor unit.
• Given that: k% K
AL
• We know we can take logarithms:
% log(K) log(L) log(A)
log(k)
• Then take time derivative of this equation
d % d d d
log(k) log(K) log(L) log(A)
dt dt dt dt
• And finally obtain
1 %
dk 1 dK 1 dL 1 dA
%
k dt K dt L dt A dt
• And the last equation becomes:
& &
k
% K
ng
%
k K
• And plugging this result into:
&
K
k% 1
K
&
%
• Yields: k %1 (g n )
% k
k
• Which can be written as:
& %
% %
k k (g n )k
Homework
• Solve for the steady state values of capital and output per
effective labor unit in our model with population growth
and productivity growth, assuming a steady state occurs.
(This means solve for the values of endogenous variables
in terms of parameters and exogenous variables)
• Calculate the steady state ratio of K to Y (called the
aggregate capital to output ratio). Is it the same as the
ratio of k to y or is it different?
• On a ratio scale, graph steady state values of K and Y
(hint the ratio scale and the logarithm scale are the
same). How fast are these variables each growing?
• On the same ratio scale, graph steady state values of k
and y. How fast are each of these variables growing?
Does this model achieve a steady
state?
• Yes
• The two lines are fixed – that is they stay in one position
– for fixed values of parameters of n, g, δ, α and
&
%
k %1
% k (g n )
k
• Graphing this equation yields the following which
illustrates how an increase in the investment rate
causes fast growth of capital per effective labor unit
initially,
• But, as the economy gets closer and closer to the
steady state, the growth rate of capital per effective
labor unit slows down
• And using the last equation it is easy to solve for
the steady state value of capital:
1/(1 )
%
k ss
gn
• And steady state output per capita comes from
putting the previous solution into the production
function: /(1 )
yss
%
gn
• This model yields the same predictions as
before:
– The farther an economy is below its steady
state the faster it grows
– The farther an economy is above its steady state
the slower it grows
We now examine the growth of
output per capita
• We can get output per capita from the definition of
output per effective labor unit. Since
Y
y
%
AL
• Multiplying both sides by A gives: If we divide by
AL we get: Y
y %
yA
L
y& y& A&
%
• This means that:
y %
y A
• And from our production function, in per effective
labor units:
yk
% %
• We know that:
&
% &
%
y k
%
%
y k
• So finally,
& &
%
y& A k
%
y A k
• Using the constant growth assumption for A, we get:
&
%
y& k
g
y %
k
• This equation tells us that:
– In the steady state y grows at the rate of g
– When the economy is below its steady state, y grows at a rate greater
than g
– And when the economy is operating above its steady state y is grows
at a rate less than g
• Thus, when the investment rate went up, y grows faster than g
for a while, but eventually the economy returns to steady state
and y growth rate returns to g
How does output per capita behave
over time?
• Recall that: yt %
ytAt
• Using our expression for A, we obtain: :
yt %
y t A 0e gt
log y t log(y
%t A 0 ) gt
Once again the model predicts
convergence and transition dynamics
• The economy converges to a steady state
for fixed values of the parameters
– In the steady state real per capita variables grow
at the rate g
• The farther below/above steady state the
faster/slower the economy will grow.
• Suppose there are two economies named
– InitiallyBehind (IB)
– InitiallyAhead (IA)
• We know that IB will grow faster in this
model
– Transitional dynamics are the driving force
behind convergence
How well do the data support the
convergence hypothesis?
We have convergence when we look
at the sample of countries for which
we have long time series