Topic 3

Growth and Accumulation

McGraw-Hill/Irwin Copyright © 2011 by The McGraw-Hill Companies, Inc. All Rights Reserved.
 Introduction
• Per capita GDP = income
per person increasing over
time in industrialized
nations, yet stagnant in
many developing nations
(Ex. U.S. vs. Ghana)
• Growth accounting
explains what part of
growth in total output is
due to growth in different
factors of production
• Growth theory explains how
economic decisions
determine the
accumulation of factors of
production
 Ex. How does the rate of
saving today affect the
stock of capital in the
future?

3-2
 The Production Function
• The production function defines relationship
between inputs
• Use the production function to study two sources
of output growth:
1. Increases in inputs (N, K)
2. Increases in productivity (technology)
• If N and K are the only inputs, the production
function is Y  AF ( K , N ) (1), where output depends
upon inputs and technology (A)
 An increase in A = increase in productivity  output
increases for given level of inputs N and K
 Assume MPN and MPK > 0, so that an increase in inputs 
increase in output
3-3
Growth Accounting Equation
• Equation (1) relates the level of output to the level
of inputs and technology
• Transform the production function into growth rate
form to show the relationship between input growth
and output growth
 The growth accounting equation is:
Y N K A
 (1  )    
Y    N 
 K
 A (2)
Nshare Ngrowth Kshare Kgrowth tech. progress

− Growth rates of K and N are weighted by their

respective income shares, so that each input
contributes an amount equal to the product of the
input’s growth rate and their share of income to output
growth
3-4
 Growth Accounting: Examples
• If   0.25, (1  )  0.75 , the • Suppose the growth rate of
growth rates of N and K are capital doubles from 3% to
1.2% and 3% respectively, and 6%. What is the growth rate of
output?
the rate of technological
progress is 1.5%, then output Y
growth is:  (0.75  1.2%)  (0.25  6%)  1.5%  3.9%
Y
Y  Output increases by less
 (0.75  1.2%)  (0.25  3%)  1.5%  3.15%
Y than a percentage point
after a 3% point increase in
• Since labor share is greater the growth rate of capital
than capital share, each 1%
point increase in labor • If the growth rate of labor
increases output by more doubled to 2.4% instead,
output growth would increase
than 1% point increase in
from 3.15% to 4.05%
capital

3-5
 Growth In Per Capita Output
• Important to consider per capita output/income since
total values might be misleading if population is large
(total output can be large even though per capita
output/income is low)
 Income for an average person is estimated by GDP per capita,
 used as an estimate for individual standard of living

• Lower case letters for is used to represent per capita

values  y  Y , k  K , where k is the capital-labor ratio
N N
Y y N K k N
• Additionally,   ,  
Y y N K k N

3-6
 Growth Accounting Equation
In Per Capita Terms
• To translate the growth accounting equation into
per capita terms, subtract the population growth
rate from both sides of equation (2) and rearrange
terms: Y N  N N K A
  (1  )   
Y N N N K A
N N N K A
    
N N N K A
N K A
   
N K A
 K N  A
   
 K N  A (3)

3-7
 Growth Accounting Equation
In Per Capita Terms

y Y N k K N
  ,  
• If y Y N k K N , then the growth
accounting equation
y k A
 
becomes y k A (4)

3-8
 Per Capita Growth

• Convergence – the process of one economy’s catching up with another

economy
• The rate of Japanese catch-up with US was greater in the early than in
the late post-war. What account for this achievement? ……

3-9
Factors Other Than N and K: Human Capital
• The production functions shown omit a long list of inputs other
than N and K
 While N and K are the most important factors of
production, others matter
• Natural resources – growth in certain countries due to
discovery and development of natural resources, i.e oil
reserve
• Investment in human capital (H) through schooling and on-
the-job training is an important determinant of output in
many economies
 With the addition of H, the production function becomes
Y  AF ( K , H , N ) (5)
 Mankiw, Romer, and Weil (1992) suggest that H contributes
equally to Y as K and N  factor shares all equal to 1/3

3-10
Growth Theory: The Neoclassical Model
• Neoclassical growth theory focuses on K accumulation and
its link to savings decisions (Robert Solow)
• Begin with a simplifying assumption: no technological
progress  economy reaches a long run level of output and
capital = steady state equilibrium
 The steady state equilibrium for the economy is the combination
of per capita GDP and per capita capital where the economy
will remain at rest, or where per capita economic variables are
no longer changing OR y  0, k  0
• Present growth theory in three broad steps:
1. Examine the economic variables that determine the economy’s
steady state
2. Study the transition from the economy’s current position to the
steady state
3. Add technological progress to the model

3-11
 Determinants of the Economy’s Steady State
• The production function in per
capita form is y = f(k) (6) and
is depicted in Figure 3-3
 As capital increases, output
increases, but at a
decreasing rate  diminishing
MPK
• An economy is in a steady
state when per capita
income and capital are
constant
 Arrive at steady state when
investment required to
provide new capital for new
workers and to replace worn
out machines = savings
generated by the economy

3-12
 Savings and Investment
• The investment required to maintain a given level of
k depends on the population growth rate and the
depreciation rate (n and d respectively) N
 Assume population grows at a constant rate, n  N , so
the economy needs nk of investment for new workers
 Assume depreciation is a constant, d, of the capital stock,
adding dk of needed investment
 The total required investment to maintain a constant level
of k is (n+d)k
• If savings is a constant function of income, s, then per capital
savings is sy
 If income equals production, then sy = sf(k)

3-13
 Solution for the Steady State
• k is the excess of saving
over required I:
k  sy  (n  d )k (7)

• k = 0 in the steady state

and occurs at values of
y* and k*, satisfying
sy*  sf (k *)  (n  d )k * (8)

• In Figure 3-4, savings and

required investment are
equal at point C with a
steady state level of
capital k*, and steady
state level of income y*
at point D

3-14
 The Growth Process
• The critical elements in the transition from the initial k to k* are
the rate of savings and investment compared to the rate of
population and depreciation growth

• Suppose start at k: sy  (n  d )k

Savings exceeds the investment required to maintain a constant

level of k
 k increases until reach k* where savings equals required
investment

3-15
 The Growth Process
Conclusions:
1. Countries with equal savings rates, rates of
population growth, and technology should
converge to equal incomes, although the
convergence process may be slow
2. At the steady state, k and y are constant, so
aggregate income grows at the same rate as
the rate of population growth, n
 Steady state growth rate is not affected by s

3-16
An Increase in the Savings Rate
• According to neoclassical growth theory, savings does
not affect the growth rate in the long run  WHY?
• Suppose savings rate increases from s to s’:
 When s increases, at k*, thus k increases to k** (and y
to y**) at point C’

sy  (n  d )k

 At point C’, the economy returns to a steady state with

a growth rate of n
 Increase in s will increase levels of y* and k*, but not
the growth rate of y

3-17
 Population Growth
• An increase in the population growth rate is illustrated by an
increase in (n+d)k  rotate line up and to the left
 An increase in n reduces the steady state level of k and y
 An increase in n increases the steady state rate of growth of
aggregate output
 The decline in per capita output as a consequence of
increased population growth is a phenomenon observed in
many developing countries (discussed in Chapter 4)
• Conversely, a decrease in the population growth rate is
illustrated by a decrease in (n+d)k  rotate line down and to
the right
 A decrease in n increases the steady state level of k and y
 A decrease in n decreases the steady state rate of growth of
aggregate output

3-18
Growth w/ Exogenous Technological Change
A
• Thus far have assumed technology is constant, 0
A
for simplicity, but need to incorporate to explain long term
growth theory

A
• If rate of growth is defined as g 
A

the production function,

y = Af(k), increases at g percent per year (refer Fig. 3-7)

• Savings function grows in a parallel fashion, and y* and k*

increase over time

3-19
 How Is A Incorporated?

• The technology parameter can enter the

production function in several ways:
1. Technology can be labor augmenting, or new technology
increases the productivity of labor Y  F ( K , AN )
y k A
  (1  )
− Equation (4) becomes y k A and y* and k*
both increase at the rate of technological progress, g

2. Technology can augment all factors, or represent total

factor productivity  Y = AF(K,N)

y k y k
− Equation (4) is   and g  
y k y k

3-20