Models of Economic Growth A

Outline:
Because this area is complex and mathematical
there are two files of slides for this topic
Lecture A
• Introduction – trends in growth
• Neoclassical growth models
Lecture B
• Endogenous growth models
• The convergence debate
Below are slides for lecture A
See next file for lecture B
 Introduction
• Need to define ‘economic growth’ (in book
this is growth in GDP per capita, not GDP
growth).
• Some background on history of economic
growth – including own country data
• Also, worthwhile to stress importance of
small differences in growth rates e.g.
2% growth per year  GDP p.c. increases 7.4 fold in 100 years
0.6%  GDP per capita increase 1.8 times in 100
.... 72 / growth rate = no. of years to double, hence China’s 10% p.a. implies 7.2 years
 The very long run
Growth of GDP per capita (average annual percentage changes)

1500-1820 1820-1900 1900-2000

OECD 1.2 2.0
Non-OECD 0.4 0.6
World 0.04 0.8 1.9
Source: Boltho and Toniolo (1999, Table 1) OECD refers to North America, Western
Europe, Japan, Australia and New Zealand.
 USA, UK and EIRE
35000
Real GDP per capita (PWT6.1, chain)
5000 15000 25000

1965 1970 1975 1980 1985 1990 1995 2000

year

GBR IRL
USA

Growth of GDP p.c: USA=2.2%, GBR=2.0%, Ireland=3.7% (but post-93, 8.5%)

GDP per capita is US$ 1996 constant prices. Source: Penn World Table 6.1
 China and India
4000
Real GDP per capita (PWT6.1, chain)
1000 2000 0 3000

1965 1970 1975 1980 1985 1990 1995 2000

year

CHN IND

Growth: pre-90 China 3.7%, India 4.4%. 1990-2000: China 7.0%, India 4.4%
Source: Penn World Table 6.1
 Brazil, S. Korea, Philippines
15000
Real GDP per capita (PWT6.1, chain)
0 5000 10000

1965 1970 1975 1980 1985 1990 1995 2000

year

BRA KOR
PHL

Source: Penn World Table 6.1 (http://pwt.econ.upenn.edu/aboutpwt.html)

 Other data
• Above are from Penn World Table 6.1, now
6.3 is available
http://pwt.econ.upenn.edu/
Some further links at:
http://users.ox.ac.uk/~manc0346/links.html
GDP per capita growth not everything
• Focusing on ‘economic growth’ does neglect health, the
environment, education, etc
• UN’s Human Development Index (HDI) gives equal weight to
life expectancy, education and GDP per capita (
http://hdr.undp.org/reports/global/2004/)
• Ultimate interest ‘well-being’ or ‘happiness’. Layard, R.
(2003). "Happiness: Has Social Science a Clue?"
http://cep.lse.ac.uk/events/lectures/layard/RL030303.pdf.
• GDP measures aggregate value added – whether coal power
station or wind farm
• Friedman, Ben (2005) The Moral Consequences of
Economic Growth argues growth is important for ‘stable’
societies
 Neoclassical model
• There are many ways to teach this. Book tends
to use equations, but can do a great deal with
intuition and few diagrams.
• This model most often attributed to Robert Solow
(1956) – US Nobel prize winner …. but Trevor
Swan (1956) (a less well known Australian
economist) published (independently) a very
similar paper in the same year – hence refer to
Solow-Swan model
 Neoclassical growth model
• Model growth of GDP per worker via capital accumulation
• Key elements:
– Production function (GDP depends on technology,
labour and physical capital)
– Capital accumulation equation (change in net capital
stock equals gross investment [=savings] less
depreciation).
• Questions:
– how does capital accumulation (net investment) affect
growth?
– what is role of savings, depreciation and population
growth?
– what is role of technology?
 Solow-Swan equations
Y  Af ( K , L) (production function)
Y GDP, A technology,
K capital, L labour
dK
sY   K (capital accumulation equation)
dt
s proportion of GDP saved (0  s  1)
 depreciation rate (as proportion) (0    1)
Solow-Swan analyse how these two equations interact.
Y and K are endogenous variables; s, and growth rate of L
and/or A are exogenous (parameters).
Outcome depends on the exact functional form of production
function and parameter values.
 Neoclassical production functions
Solow-Swan assume:
a) diminishing returns to capital or labour (the ‘law’ of
diminishing returns), and
b) constant returns to scale (e.g. doubling K and L, doubles Y).
For example, the Cobb-Douglas production function

Y  AK  L1  where 0    1
 1   
Y AK L AK K
y     A    Ak 
L L L L
Hence, now have y = output (GDP) per worker as
function of capital to labour ratio (k)
 GDP per worker and k
Assume A and L constant (no technology growth or
labour force growth)
y
output per worker

y=Af(k)=Aka

concave slope reflects

diminishing marginal
product of capital
dY/dK=dy/dk=aAka-1

k
(capital per worker)
 Accumulation equation
dk
If A and L constant, can show* sy   k
dt
This is a differential equation. In words, the change in
capital to labour ratio over time = investment (saving) per
worker minus depreciation per worker.

Any positive change in k will increase y and generate

economic growth. Growth will stop if dk/dt=0.
dK dK
*accumulation equation is: sY   K , divide by L yields / L sy   k
dt dt
dk K dK
Also note that, d   / dt  / L since L is a constant.
dt L
  dt
Graphical analysis of dk
sy   k
(Note: s and  constants) dt
y
dk
output per worker

(depreciation)

net investment sy
(savings = gross
investment)

k (capital per worker)

k*
 Solow-Swan equilibrium
output per worker
y y=Aka

y*
consumption
per worker
dk
sy

k
k*

GDP p.w. converges to y* =A(k*). If A (technology) and L

constant, y* is also constant: no long run growth.
 What happens if savings increased?
• raising saving increases k* and y*, but long run
growth still zero (e.g. s1>s0 below)
• call this a “levels effect”
• growth increases in short run (as economy moves to
new steady state), but no permanent ‘growth effect’.
y y=Aka
y1 *

y0 *
dk
s1y
s0y

k0 * k1 *
 What if labour force grows?
dk dL
Accumulation eqn now sy  (  n)k where n  / L (math note 2)
dt dt
y
y
Population growth
reduces
equilibrium level output per worker
of GDP per
dk
worker (but long (d+n)k
run growth still sy
zero) if
technology static
Population growth (n>0)
pivots the ‘depreciation’
line upwards, and reduces
k and y steady state

kn* k
 Analysis in growth rates
Can illustrate above dk
dk dt  g s y  (  n)
with graph of gk and k sy  (  n)k  k
dt k k
growth rate of capital per worker
Distance between lines is

Distance
y between lines represents growth
net s per
in capital s worker
average(gproduct
k)
of capital
investment k

d+n
net disinvestment

k* k
capital per worker
 gk y y
Rise in s0
k
s1
k
savings rate B
(s0 to s1) C
d+n
A

k* k
g Y, g k
gY=(MPK/APK) gk = sk gk
NB: This graph of (sk = a in Cobb-Douglas case)
how growth rates
change over time
0%
Time
y
Saving change s1
k
 Golden rule
• The ‘golden rule’ is the ‘optimal’ saving rate (sG)
that maximises consumption per head.
• Assume A is constant, but population growth is n.
• Can show that this occurs where the marginal
product of capital equals (n)

dk
Proof: sy  (  n) k 0 at steady state,
dt
hence sy (  n)k , where * indicates steady state equilibrium value
The problem is to: max c  y  sy  y *  (  n) k 
k

dy * dy *
First order condition : 0  (  n) hence MPk =   n
dk * dk *
 Graphically find the maximal
distance between two lines
y y
output per worker

slope=dy/dk=n+d

y** maximal
(n+d)k
consumption
per worker
sgold y

k
k**
capital per worker
 … over saving
y y=Aka
output per worker

slope=dy/dk=n+d
sovery
y** maximal
consumption
per worker (n+d)k
sgoldy

k
k** k*
capital per worker
Economies can over save. Higher saving does increase GDP
per worker, but real objective is consumption per worker.
Golden rule for Cobb Douglas case
• Y=KL1- or y = k
• Golden rule states: MPk = k*)-1 =(n + )
• Steady state is where: sy* = ( +n)k*
• Hence, sy* = [k*)-1]k*
or s = k*) / y* = 
Golden rule saving ratio =  for Y=KL1-case

Assuming perfect competition, and factors are paid marginal

products,  is share of GDP paid to capital (see C&S, p.481).
Expect this to be 0.1 to 0.3.
 Solow’s surprise*
• Solow’s model states that investment in capital cannot
drive long run growth in GDP per worker
• Need technological change (growth in A) to avoid
diminishing returns to capital
• Easterly (2001) argues that “capital fundamentalism”
view widely held in World Bank/IMF from 60s to 90s,
despite lessons of Solow model
• Policy lesson: don’t advise poor countries to invest
without due regard for technology and incentives
* This is title of Chapter 3 in Easterly (2001), which is worth a quick read for
controversy surrounding growth models and development issues
 What if technology (A) grows?
• Consider y=Ak, and sy=sAk, these imply that
output can go on increasing.
• Consider marginal product of capital (MPk)
MPk=dy/dk =Ak,
if A increases then MPk can keep increasing (no
‘diminishing returns’ to capital)
• implies positive long run growth
…. graphically, the production function
simply shifts up
Technology growth: 2 y=A2ka
y
A 2 > A1 > A 0
y=A1ka
y=A0ka
1
output per worker

dk

k
Capital to labour ratio
 …. mathematically
Easier to use Y K  ( AL)1  where 0    1
(This assumes A augments labour (Harrod-neutral technological change)
Can re-write K  ( AL)1   A1  K  L1 
dA
Assume / A  g A (for reference this same as A t A o e g At )
dt
Trick to solving is to re-write as
 1  
Y K ( AL)  K   )
y   =  ( k
AL AL  AL 
where y =output per 'effective worker', and k capital per 'effective worker'
dk 
Can show / k s( k )  ( n  a   )k
dt
This can be solved (plotted) as in simpler Solow model.
 Output (capital) per effective worker diagram
Y/AL Y/AL
output per effective worker

(Y/AL)*
NOTE: ‘dilution’ line now
includes technology growth (a)

(n+a+d)k
s(Y/AL)

(K/AL)* K/AL
capital per effective worker

If Y/AL is a constant, the growth of Y must equal the growth rate

of L plus growth rate of A (i.e. n+a)
And, growth in GDP per worker must equal growth in A.
 Summary of Solow-Swan
• Solow-Swan, or neoclassical, growth model, implies
countries converge to steady state GDP per worker (if
no growth in technology)
• if countries have same steady states, poorer countries
grow faster and ‘converge’
– call this classical convergence or ‘convergence to steady
state in Solow model’
• changes in savings ratio causes “level effect”, but no
long run growth effect
• higher labour force growth, ceteris paribus, implies
lower GDP per worker
• Golden rule: economies can over- or under-save (note:
can model savings as endogenous)
 Technicalities of Solow-Swan
• Textbooks (Jones 1998, and Carlin and Soskice 2006) give
full treatment, in short:
• Inada conditions needed ( “growth will start, growth will
stop”) dY dY
lim 0, lim ,
K  dK K 0 dK
• It is possible to have production function where dY/dK
declines to positive constant (so growth declines but never
reaches zero)
• Exact outcome of Solow model does depend on precise
functional forms and parameter values
• BUT, with standard production function (Cobb-Douglas)
Solow model predicts economy moves to steady state
because of diminishing returns to capital (assuming no
growth in technology A)
 Endnotes
Math note 1: yt  y0 e gt can be used to analyse impact of growth over time
Let y=GDP p.w., g=growth (e.g. 0.02 2%), t=time.
Hence, for g 0.02 and t 100, yt / y0 e 2 7.39

Math Note 2:
dK dK
Start with sY   K , divide by L yields / L sy   k
dt dt
dk K  dK dL  2
Note that d   / dt  L K  /L (quotient rule)
dt L
   dt dt 
dK  dL  K dK
simplify to /L  / L or / L  nk (since n is labour growth and K / L k )
dt  dt L dt
dk dK
hence +nk = / L sy   k
dt dt
dk
hence =sy  (  n)k
dt
 Questions for discussion
1. What is the importance of diminishing marginal
returns in the neoclassical model? How do other
models deal with the possibility of diminishing
returns?
2. Explain the effect of (i) an increase in savings
ratio (ii) a rise in population growth and (iii) an
increase in exogenous technology growth in the
neoclassical model.
3. What is the golden rule? Can you think of any
countries that have broken the golden rule?
 References
Boltho, A. and G. Toniolo (1999). "The Assessment: The
Twentieth Century-Achievements, Failures, Lessons." Oxford
Review of Economic Policy 15(4): 1-18.
Easterly, W. (2001). The Elusive Quest for Growth: Economists’
Adventures and Misadventures in the Tropics. Boston, MIT Press.
Swan, T. (1956). "Economic Growth and Capital Accumulation."
Economic Record 32: 344-361.
Jones, C. (1998) Introduction to Economic Growth, (W.W. Norton,
1998 First Edition, 2002 Second Edition).
Carlin, W. and D. Soskice (2006) Macroeconomics:
Imperfections, Institutions and Policies, Oxford University Press.