Intermediate Macroeconomics

Chapter 9. Economic Growth II:

Technology, Empirics, and Policy

Professor Yongwook Kim

Shanghai University of Finance and Economics

October 11, 2024

Professor Yongwook Kim (Shanghai University of Finance

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and Economics)
Macroeconomics October 11, 2024 1 / 37
 Today’s Lecture

How to include technological progress in the Solow model.

Growth empirics: comparing the theory with real-world data.
Policies to promote economic growth.
Two basic models in which technological progress is determined
endogenously.

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 Introduction

In the Solow model:

The production technology is assumed to be constant.
Income per capita remains constant in the steady state.
However, neither of these assumptions holds true in reality:
From 1900 to 2013, U.S. real GDP per person grew at an average rate
of 1.9% per year.
There are numerous examples of technological progress driving
economic growth.

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 Technological progress in the Solow model
Introduce a new variable, E , representing the e!ciency of labor.
As technology improves, each hour of work becomes more productive,
contributing more to the production of goods and services.
The model assumes that technological progress is labor-augmenting,
meaning it increases labor e!ciency at an exogenous rate g :
”E
g=
E
We can then write the production function as:

Y = F (K , L → E )

where L → E represents the e#ective number of workers.

Increases in labor e!ciency have the same impact on output as
increases in the labor force.
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 (Continued)
Notation:
y = Y /(LE ) = output per e#ective worker
k = K /(LE ) = capital per e#ective worker

Production function per e#ective worker:

y = f (k)

Saving and investment per e#ective worker:

sy = sf (k)

The evolution of k over time:

”k = sf (k) ↑ (ω + n + g )k

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 (Continued)

Break-even investment is given by (ω + n + g )k:

This represents the amount of investment needeed to keep k constant.
The break-even investment includes:
ωk to replace depreciating capital.
Basic Mnk to provide capital for new workers entering the labor force.
Advanced M
gk to provide capital for the new ”e#ective” workers created by
. technological progress

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Macroeconomics October 11, 2024 6 / 37
Professor Yongwook Kim (Shanghai University of Finance
Intermediate
and Economics)
Macroeconomics October 11, 2024 7 / 37
Professor Yongwook Kim (Shanghai University of Finance
Intermediate
and Economics)
Macroeconomics October 11, 2024 8 / 37
 The Golden Rule with Technological Progress

To find the Golden Rule capital stock, express c → in terms of k → :

c→ = y→ ↑ i→
= f (k → ) ↑ (ω + n + g )k →

c → is maximized if
MPK = ω + n + g
or equivalently,
MPK ↑ ω = n + g
This means that, in the Golden Rule steady state, the marginal
product of capital, after accounting for depreciation, is equal to the
population growth rate plus the rate of technological progress.

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 Growth Empirics: Balanced Growth

= ye .
The steady state of the Solow model exhibits balanced growth, where
multiple variables grow at the same rate.

The model predicts that both output per worker (Y /L) and capital per
worker (K /L) grow at the same rate ,g . As a result, the ratio K /Y
remains constant, which aligns with the real-world observations.

The Solow model also predicts that the real wage grows at the same
rate as Y /L, while real rental price of capital remains constant.
These predictions are also consistent with real-world data.

W
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 Growth Empirics: Convergence

The Solow model predicts that, all else being equal, poor countries
(with lower Y /L and K /L) should grow faster than richer ones.
If this prediction held true, the income gap between rich and poor
countries would shrink over time, leading to a convergence in living
standards.
However, in reality, many poor countries do not grow faster than rich
ones. Does this mean the Solow model is incorrect?
No, because “all else” is not equal:
In samples of countries with similar cultures and policies, income gaps
shrink at a rate of about 2% per year.
In larger samples, after controlling for di#erences in savings rates,
population growth, and human capital, incomes still converge by
roughly 2% per year.

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 (Continued)

What the Solow model predicts is conditional convergence

-countries converge to their own unique steady states, which depend
on factors like savings rates, population growth, and education.
In other words, each country has a di#erent steady state based on its
specific characteristics.
This prediction is consistent with what we observe in the real world.

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 Growth Empirics:
Factor Accumulation vs. Production E!ciency

Di#erences in income per capita between countries can be attributed

to di#erences in:
1. Capital per worker - both physical and human capital.
2. The e!ciency of production (i.e. the height of the production function)
Studies show that:
Both capital per worker and production e!ciency are important.
These two factors are also correlated.
Possible explanations for the correlation:
Higher production e!ciency encourages greater capital accumulation.
Capital accumulation has externalities that improve production
e!ciency.
A common factor, such as the quality of a nation’s institutions, may
lead to higher levels of both capital accumulation and production
e!ciency in certain countries.

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Macroeconomics October 11, 2024 13 / 37
 Policy Issues

1 Are we saving enough? Too much?

2 What policies might change the saving rate?
3 How should we allocate our investment between privately owned
physical capital, public infrastructure, and human capital?
4 How do a country’s institutions a#ect production e!ciency and
capital accumulation?
5 What policies might encourage faster technological progress?

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 #
Policy Issues: Evaluating the Rate of Saving

Use the Golden Rule to determine whether the U.S. saving rate and
capital stock are too high, too low, or about right.
The economy is below the Golden Rule steady state and should
increase the saving rate s,

if MPK ↑ ω > n + g

The economy is above the Golden Rule steady state and should
reduce the saving rate s,

if MPK ↑ ω < n + g ,

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 A Numerical Example
neE
Estimate (MPK ↑ ω), using three facts about the U.S. economy:
Oly
1. The capital stock is about 2.5 times one year’s GDP.

k = 2.5y

2. About 10% of GDP is used to replace depreciating capital.

ωk = 0.1y

e
3. Capital income is about 30% of GDP.

MPK → k = 0.3y

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 (Continued)

From the last example, MPK ↑ ω = 0.08

U.S. real GDP grows an average of 3% per year, so n + g = 0.03
Thus,
MPK ↑ ω = 0.08 > 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.

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 Policy Issues: How to Increase the Saving Rate

Reduce the government budget deficit

(or increase the budget surplus).
Increase incentives for private saving:
1. Reduce taxes such as capital gains tax, corporate income tax, and
estate tax, as these reduce the rate of return and discourage saving.
2. Replace federal income- taxconsumption
.
saving
with a consumption tax.
3. Expand tax-exempt retirement accounts, such as IRAs and other
savings accounts for retirement.
There are di#erent perspectives on how much private saving responds
to these incentives.

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 Policy Issues: Allocating the Economy’s Investment

In the Solow model, there is one type of capital.

In the real world, there are three categories of capital:
1. private capital stock
2. public infrastructure, such as roads, bridges, and sewer systems
3. human capital, which includes the knowledge and skills that workers
gain through education
Human capital is at least as crucial as physical capital in explaining
international di#erences in living standards.
How should investment be allocated among these types of capital?

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 (Continued)
Two viewpoints:
1. Equal Treatment Approach: The government should equalize tax
treatment across all types of capital and industries, then let the
market allocate investment e!ciently.
2. Industrial policy: The government should actively promote investment
in specific types of capital or industries, particularly those with
positive externalities that private investors may not consider.

Potential issues with industrial policy:

The government may lack the expertise to accurately identify the
most promising industries—those with the highest returns or the
greatest positive externalities.
Political influences, such as campaign contributions, may a#ect which
industries receive preferential treatment rather than decisions based
on sound economic reasoning.
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Macroeconomics October 11, 2024 20 / 37
 Policy Issues: Establishing the Right Institutions

Economists argue that the international di#erences in standard of living

arise from:
1 Di#erences in physical and human capital inputs.
2 Di#erences in productivity due to the institutions that guide how
scarce resources are allocated.
Therefore, establishing the right institutions is crucial to ensure that
resources are allocated e!ciently.
Examples of such institutions:
Legal institutions, to protect property rights
Capital markets to direct financial capital to the best investment
opportunities.
A corruption-free government to promote competition, enforce
contracts, and maintain fair economic practices.

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 Policy Issues: Encouraging Technological Progress

The following policies encourage the private sector to invest in

technological innovation:
Patent laws: Provide inventors with a temporary monopoly on new
products, incentivizing innovation.
Tax incentives for R&D: O#er tax breaks to companies engaging in
research and development activities.
Grants for fund basic research: Fund fundamental research at
universities to advance scientific knowledge.
Industrial policy: Support specific industries that are crucial for rapid
technological advancement.

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 Endogenous Growth Theory

Solow model: -big

Sustained growth in living standards is attributed to technological
progress. =
Ok sfir) -1814191h
The rate of technological progress is considered exogenous.
Endogenous growth theory: C
A set of models where the growth rate of productivity and living
standards is determined endogenously (within the model).

Investment
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 1. The Basic Model

Production function:
Y = AK
Ad
fixed
where A represent the amount of output per unit of capital
(exogenous and constant)
Key di#erence from the Solow model:
In this model, the MPK is constant, whereas in the Solow model,
it diminishes as capital increases.

F
Investment: sY
Depreciation: ωK
Equation of motion for total capital:

”K = sY ↑ ωK

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 (Continued)

From the production function,

”Y ”A ”K ”K
= + =
Y A K K
By dividing the motion for capital by K and using Y = AK , we get:
”Y ”K
= = sA ↑ ω
Y K
If sA > ω, then income will grow forever, and investment is the
“engine of growth.”
Here, the permanent growth rate of Y depends on the saving rate s.
In the Solow model, it does not.

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 Does Capital Have Diminishing Returns or Not?

The answer depends on how capital is defined.

If capital is defined narrowly (only including plant and equipment),
then the assumption of diminishing returns to capital may hold.
Advocates of endogenous growth theory argue that human capital
should also be considered a form of capital.
If human capital is included, then constant returns to capital become
more plausible, making this model a reasonable representation of
economic growth.

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Intermediate
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Macroeconomics October 11, 2024 26 / 37
 2. A Two-sector Model
There are two sectors:
Manufacturing: Firms produce goods.
Research: Universities produce knowledge that enhances labor e!ciency
in manufacturing.
u: The fraction of labor dedicated to research (assumed exogenous)
Manufacturing production function:

Y = F [K , (1 ↑ u)EL]

This production function exhibits constant returns to capital.

Research production function:

”E = g (u)E

Capital accumulation:
”K = sY ↑ ωK
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Intermediate
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Macroeconomics October 11, 2024 27 / 37
 (Continued)

In the steady state, manufacturing output per worker and the

standard of living grow at the rate:
”E
= g (u)
E
Key variables:
s (saving rate): A#ects the level of income, but not its growth rate
(similar to the Solow model)
u (fraction of labor in research): Influences both the level and the
growth rate of income.
Question: How would increasing u benefit the economy?
What are the potential costs of increasing u?

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Intermediate
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 3. The Romer Model (Optional) solr nochet
closed
This model is also a two-sector model, but instead of focusing on labor
seco

e!ciency, it introduces knowledge (or ideas) into the output production

function.
Output production function:

Yt = At Lyt

where At represents the amount of knowledge/ideas, and Lyt is the

number of manufacturing workers.
Idea production function:

”At+1 = z̄At Lat

where z̄ is the e!ciency of research, and Lat is the number of

researchers.

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Macroeconomics October 11, 2024 29 / 37
 (Continued)
Resource constraint:
Lyt + Lat = L̄
Allocation of labor:
Lat = u L̄

Step 1:
”At+1 = z̄At Lat = z̄At u L̄
Step 2:
”At+1
= z̄u L̄ ↓ ḡ
At
Thus, At = Ā0 (1 + ḡ )t
Step 3
Yt
yt = = At (1 ↑ u) = Ā0 (1 ↑ u)(1 + ḡ )t
L̄
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 Facts about R&D

1. A significant portion of research is conducted by firms seeking profits.

2. Firms profit from research in two main ways:
Patents generate a stream of monopoly profits.
Gain extra profit from being the first to market with a new product.
3. Innovation also creates externalities that reduce the costs of future
innovations.
↔ The newer endogenous growth theory aims to incorporate these facts
into models to better understand the nature of technological progress.

Professor Yongwook Kim (Shanghai University of Finance

Intermediate
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Macroeconomics October 11, 2024 31 / 37
 Is the Private Sector Doing Enough R&D?

Positive externalities in the creation of knowledge suggests that the

private sector may be underinvesting in R&D.
However, there is also significant duplication of R&D e#orts among
competing firms.
Estimates: The social return on R&D is at least 40% per year.
Therefore, many believe that the government should take steps to
encourage R&D.

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Intermediate
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 Economic Growth as “Creative Destruction”

Schumpeter (1942) coined the term “creative destruction” to describe

the disruptions caused by technological progress:
The new products benefits consumers but can be detrimental to
incumbent produces, who may be pushed out of the market.
Examples:
The Luddites (1811-12) destroyed machines that replaced skilled
knitting workers in England.
Walmart has displaced many smaller, local “mom-and-pop” stores.

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 Accounting for the Sources of Economic Growth:
No Technological Progress
Production function:
Y = F (K , L)
The output changes only when the amount of capital (K ) or labor (L)
changes.
Increase in Capital:

MPK = F (K + 1, L) ↑ F (K , L) ↔ ”Y = MPK → ”K

where MPK is the marginal product of capital.

Increase in Labor:

MPL = F (K , L + 1) ↑ F (K , L) ↔ ”Y = MPL → ”L

where MPL is the marginal product of labor.

Professor Yongwook Kim (Shanghai University of Finance
Intermediate
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Macroeconomics October 11, 2024 34 / 37
 (Continued)

Increases in Capital and Labor:

”Y = (MPK → ”K ) + (MPL → ”L)

After rearranging, the equation becomes

”Y ! MPK → K " ”K ! MPL → L " ”L
= +
Y Y K Y L
”K ”L
=ε + (1 ↑ ε)
K L
where ε represents capital’s share of output, and (1 ↑ ε) represents
labor’s share of output.

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Intermediate
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Macroeconomics October 11, 2024 35 / 37
 Accounting for the Sources of Economic Growth:
Technological Progress
Production function:
Y = AF (K , L)
Output changes due to changes in capital (K ), labor (L), and total
factor productivity (A).
The equation for economic growth is:
”Y ”K ”L ”A
=ε + (1 ↑ ε) +
Y K L A
Since A is not directly observable, it is measured indirectly as:
”A ”Y ”K ”L
= ↑ε ↑ (1 ↑ ε)
A Y K L
”A/A represents the change in output that cannot be explained by
changes in capital or labor. It is also known as the Solow residual.
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Macroeconomics October 11, 2024 36 / 37
 The Sources of Growth in the United States

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