Econ 620 2013

2. Growth Theory 2.1 The effects of growth

Canadian real per capita GDP grew by a factor of 15 from CAN $1,694 in 1870 to CAN $25,297 in 2011. The average growth rate over this period was 1.91%1.

Canadian per capita GDP

30,000 25,000 20,000 15,000 10,000 5,000 0

What if the growth rate was 0.8% (like the Peru from 1960-1997)? In that case current real per capita GDP would have been CAN $5,193 barely 3 times that of 1870. Canadian average income will be close to the level of Dominican Republic. What if the growth rate was 2.93% (like Israel from 1960-1997)? In that case current real per capita GDP would have been CAN $102,450, 60 times the income of 1870 and more than 4 times its current income. Comparing with your grandparents2 (born 50 years / 2 generations ago)

Most of the calculations are based on the data that I have posted in WebCT. When we look at

1870 1875 1880 1885 1890 1895 1900 1905 1910 1915 1920 1925 1930 1935 1940 1945 1950 1955 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010

Econ 620 2013 Taiwan (5.6%) Zaire (-1.8%) Canada (1.6%) 16 times richer had 40% of what your grandparents had 2.2 times richer

Small differences in growth rate lead to vast differences in per capita income when compounded over long periods of time. Comparing real per capita GDP over the last century involves multiples as high as 20. But comparing levels at a point in time across countries exhibit even larger (and increasing) multiples.
GDP per capita/ CAN GDP per capita 1.5 1 0.5 THA MDG LSO CRI GMB CHN GAB ZMB GRC AUS PHL BFA IDN 0 ZAR NZL USA

Zaire Canada

1950 1,026 19,473 19

2004 531 35,281 66

Growth -1.83% 1.60%

Another way to think about it is that an average citizen of Zaire has to live for a whole year with the income that an average Canadian worker earns in less than 6 days (we always work with real values, so everything is adjusted for price differences across countries). These stunning differences in income per capita are the result of wide differences in the growth rates (data between 1960 and 1997).

How long does it take to double income? If output grows at an exponential rate, we are interested in the log value of t that satisfies; ye gt = 2 y gt = ln 2 t = ln 2 / g = 0.69 / g

GBR

KOR

JOR

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Average per capita GDP growth 1960-1997

8% 6% 4% 2% 0% -2% -4%

Average per capita GDP growth 1960-2000

35 30 25 20 15 10 5 0 <0% 0%-1% 1%-2% 2%-3% 3%-4% >4%
Zambia Nicarag ua M ozambique B olivia V enezuela Nig eria A ustralia C hile C anada US UK M aurtitius France Israel India B razil S pain C hina G reece Indonesia M alaysia Thailand J apan Hong Kong S ing apore S . Korea

2.1.1 The importance of growth.

a) Growth vs. business cycles. During the 2007-2009 recession, Canadian per capita RGDP fell by 5.6%, over a period of 2 years3. This is equivalent to a permanent reduction4 in the growth rate of one twentieth of one percentage point. RGDP at the lowest point in the recession was higher than anytime in history before 2004. If this is the correct way of measuring wellbeing it seems that the welfare consequences of growth are substantially more important than the effects of the business cycle.
3

Canadian per capita GDP peaked in 2007 at $25,800 then it fell to $24,361 in 2009 reaching $25,297 in 2011. 4 By permanent I mean for 100 years.

Econ 620 2013

Lucas (1987) formalized this point in the following way. The present value of intertemporal utility depends on the evolution of consumption, which in turn depends on the initial level of consumption, its growth rate and its variance.

C1 t U = E e dt ; 0 1

= 2.5

(1)

Assume that 0 is the historical average of consumption growth recovered from the data,
2 2 and 0 its variance, so lets define U C0 , 0 , 0 as the value of (1) for an initial level of consumption C0 , and the growth rate and variance over the last 50 years of US per capita consumption.

1. How much is an agent willing to pay in terms of current consumption to increase growth permanently by 1%?
where 2 2 U 1 = 0 + 1% C0 , 1, 0 = U C0 , 0 , 0

= .7 , so the agent is willing to reduce current consumption by 30%

2. How much is an agent willing to pay in terms of current consumption to get rid of all the business fluctuations?
2 U [C0 , 0 ,0] = U C0 , 0 , 0

= .996 , so the agent is willing to reduce current consumption by less than 0.5%
These results are difficult to believe. They are driven partly from the assumption about preferences (separable across time and households), the use of per capita data that hides individual variation, the absence of market incompleteness But surprisingly the results do not change that much when you allow for financial market imperfections, absence of unemployment benefits b) Other measures of welfare. Income per capita is positively correlated with life expectancy, the inverse of child mortality, access to drinking/potable water, literacy and other welfare indicators (the direction of causality is unclear).

Econ 620 2013

% of population im m unized for m easles vs. GDP per capita

100 90 80 70 60 50 40 30 20 10 0 100 1000 10000 100000
120 100 80 60 40 20 0 100

% of population w ith access to sanitation facilities vs. GDP per capita

1000

10000

100000

% of population w ith im proved w ater access vs. GDP per capita

120 100 80 60 40 20 0 100 1000 10000 100000 90 80 70 60 50 40 30 20 10 0

Years of life expectancy vs. GDP per capita

100

1000

10000

100000

(From left to right). Sub-Saharan Africa, East Asia and Pacific, Middle East and North Africa, Latin
America and Caribbean, High Income.

c) Growth, Inequality and Poverty. A rising tide lifts all the boats. There is a growing agreement that it is difficult to eradicate poverty by redistributing existing wealth, therefore creation of new wealth seems to be the most promising avenue to improve the standard of living of the poor. Redistribution does not only affect the allocation of the pie, but also its size sometimes in good ways, access to opportunities, but other times in harmful ways distorting incentives. What are the effects of growth on the world poorest? What is the evolution of the world income distribution? Lets use the World Bank definition of the poverty line, $1 a day 1985 prices, although we can think that its level is arbitrary, most people still think that its evolution is informative. Lets see what has happened over the last 40 years.

Econ 620 2013 * The world income distribution has shifted to the right (cumulative growth). World average per capita income increased from $4,250 to $7,200.

* Across country inequality has increased very little (China and India account for 1/3 of the world population), with a considerable increase in the density of relatively rich countries, while many countries still remain quite poor5. Within country inequality has increased (China, US).

Source: Acemoglu (2007)

* Between 1970 and 1998 the percentage of people below the poverty line moved from 17% to 7%, from 575 million to 375 million6, even when the world population increased by 2.5 billions.
5

It is natural to look at the log of variables that grow over time. Since growth rates are approximately proportional, i.e. leading to exponential growth, when we take the log of income the resulting variable is approximately linear. 6 Sala-i-Martin data recovers each countrys income distribution by combining per capita GDP (to match the mean) with income shares per quintiles extracted from household surveys (to match the dispersion). The World Bank poverty counts are substantially higher but they exhibit a similar tendency (see More or Less equal)

Econ 620 2013

Poverty Rates ($570)

60%

50%

40%

30%

20%

10%

0% 1970 Af rica

1975 Latin America

1980 East Asia

1985 South Asia

1990 Middel East and NA

1995

2000

Eastern Europe and CA

Poverty Counts ($570)

400,000 350,000 300,000 250,000 200,000 150,000 100,000 50,000 0 1970 Af rica

1975 Latin America

1980 East Asia

1985 South Asia

1990 Middel East and NA

1995 Eastern Europe and CA

2000

Source: Sala-i-Martin (2002) (counts are in 1,000s) (is the equivalent to the 1985 prices $1 poverty line)

In terms of poverty reduction the data suggests that the positive effect of growth more than overcomes the negative effect of increasing inequality. The largest reductions in poverty took place in countries that experienced high growth (Asia) while the largest increases in poverty took place in low growth areas (Africa).

Source: Acemoglu (2007)7

Notice that an increase in 1 unit in log GDP is equivalent to an increase in GDP by a factor of 2.71. Since there is a difference in log GDP between the Western Offshoots and Africa of 3, then the Western Offshoots GDP is around 20 times ( e3 ) higher than the African one.

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2.1.2. Kaldors Stylized Facts

Lets assume there are two primary inputs of production8; capital, K (machines, structures, public infrastructure, tools, computers) and labor, L . Lets define some variables: is aggregate profits (i.e. the payments to capital for its contribution to output), W is aggregate wages (i.e. the payments to labor for its contribution to output), W is the return to capital, w is the wage rate, Y is aggregate net income9 (net r K L national product). Notice that the sum of profits and wages is equal to aggregate income, the basic accounting identity, NP NI Y = W + . As a result the share of income that goes to capital, i.e. the capital income share is just . Finally lets define net Y = I and therefore the investment/saving rate is given by K = I . investment as K Y Y Kaldor (1958) summarized the following stylized facts, i.e. a set of empirical regularities, about the behavior of industrialized economies. 1. Per capita output grows at a more or less constant rate over fairly long periods of time. 2. The capital-output ratio shows no trend. 3. The return to physical capital shows no trend. 4. A wide variety of growth rates (and levels) of income per capita. (This one was added afterwards, but we have already seen the cross country evidence)
Canadian Output Growth 20.00 15.00 10.00 5.00 1931 1937 1943 1949 1961 1967 1973 1979 1991 1955 -5.00 -10.00 -15.00 -20.00 -25.00 1985 1997 0.00
3 2.8 2.6 2.4 2.2 2 1.8 1.6 1.4 1.2 1 Canadian K/Y

1950

1954

1958

1962

1966

1970

1974

1978

1982

Many intermediate goods are used in production of final output, GDP, but we can think that those intermediate goods are also combinations of capital and labor. In this sense it seems natural to restrict to these two primary inputs; capital and labor. 9 The sub-index i representents per capita (per worker) quantities. Notice that the ratio of two aggregates is equivalent to the ratio of two per capita variables,

X X L Xi . = = Z Z L Zi

1986

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Canadian Real Interest rate

9 4 1960 1964 1968 1972 1976 1980 1984 1988 1992 1996 2000 -1 -6 -11

K > 0 , we reach =Y > 0 and more or less Combining (2) i = 0 , with (3), Y K i i i Y i constant. So the capital labor ratio grows at a positive rate, more or les constant.
Combining this finding with (2) we reach that the net investment rate (savings rate in a closed economy) is also trend-less.

I I i I i Yi K K i is more or less constant i i Ki Yi K i Yi

(2) + (3) imply that the factor income shares exhibit no trend.

Y = is also constant. K Y K Y

Furthermore, since Y W + then the labor income share,

W , is also constant. Y

This last fact implies that the wage grows at a positive and stable rate.

W WY Y = 0 + = Y w = w i >0 L Y L L

2.1.3. Modeling economic growth

Demand Side Preferences Supply Side Production Technology Time dimension

In general most of the models in the growth literature share the same underlying structure. Households in the demand side of the economy decide how much of their

Econ 620 2013 income they are willing to consume (or how many hours to work, or how many children to raise) to satisfy their current needs and how much are they willing to save/invest to increase their future production possibilities. This saving-consumption decision cannot be understood without the introduction of the supply side of the model, where the amount saved is transformed into future output. The interaction between the rate of transformation of saving into future output (production function) and willingness of household to sacrifice current consumption for future one (preferences) determines the optimal decision rule to allocate current output into its alternative uses, consumption and saving10. Finally it is important to notice the dynamic nature of the growth problem. Our current choices will affect our future production and consumption possibilities. Through our models we are trying to capture some generalities that are common across economies. Each economy or each period in time has a set of particularities that need to be taken into account for a complete understanding of any issue. This is a point we should always keep in mind.

All the models we are going to work with in the growth part are supply-side models, where Says law fully applies. In these models supply of loanable funds, saving, creates its own demand, investment. Supply of labor, i.e. population growth, creates its own demand, determining the level of employment. In any of these models there are no idle resources, so we can think of all these theories as theories for the evolution of potential output (at any point in time the business cycle will account for the deviation between potential and actual output). Is this assumption realistic in general? What about for our particular purpose? The 10-fold difference in output per capita we experienced in the last century is a supply or a demand phenomenon? The difference between an average citizen of Zaire and the average Canadian one resides in their willingness to buy or in their ability to produce?

10

10

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2.2. The Neoclassical Growth Model

2.2.1 The Solow model without technological change. 3.2.1.1. Description of the model
The demand side is summarized by an exogenously given saving rate, s. Each period a fixed proportion of output is saved/invested. In the supply side we need to specify, a) The production technology. b) The laws of motion of the inputs.

- The production function.

Our model economy produces only one homogeneous commodity, output (Y ( t ) ) . There is a supply of homogeneous labor ( L ( t ) ) which is used, together with the stock of capital ( K ( t ) ) according to the following neoclassical technology, that for simplicity we assume to be of the Cobb-Douglas form 11
Y = F [ K , L ] = K L1

1. F(.) exhibits positive and diminishing marginal products, F 2F > 0, 2 < 0 K K So holding L constant, Y is increasing in K but at a decreasing rate. The same applies for labor. 2. Inada conditions,

F F = 0; lim = K K K 0 K lim

11

I have in mind a broad definition of capital that includes tools, machinery, buildings, public and private infrastructure one of the key features of capital is its reproducible nature, capital as opposed to most natural resources could be produced. To think about economic growth before the industrial revolution will require the introduction of land as an additional input, for modern capitalist economies this distinction seems unnecessary. For instance, in Britain, where long time series are available, the value of non-urban land as a percentage of total wealth has decreased from 65% at the beginning of the 18th century to 2% nowadays. For the U.S. in 1995 the share of oil purchases over GDP was 3.5% according to the Energy Information Administration, an agency of the U.S. Government.

11

Econ 620 2013 An equivalent condition applies for labor. 3. Constant returns to scale in capital and labor. We want a technology that if we have twice as much labor and capital we produce twice as much output. Mathematically the production function is homogeneous of degree 1 if,
F [cK , cL ] = cF [ K , L ]

where c > 0 is any positive constant. Furthermore, for functions homogenous of degree 1 Eulers theorem implies that FK K + FL L = Y . As a result if markets are competitive, since factors are paid their marginal products, output is exhausted by the payments to the factors of production. Since the stylized facts we are interested in explaining involve per capita output it will be convenient to re-write the production function in per capita terms,

Y =K L

K then = L = LK i Yi = K i L

Where the subscript i denotes per capita variables. - Evolution of the inputs. Labor/Population is assumed to evolve exogenously at the exponential rate, n.

= n, given L ( 0 ) = L L L ( t ) = L0e nt 0
Final output can be consumed or invested (saved). The fraction of output devoted to investment, s, is exogenous and constant, and the existing capital stock depreciates at a rate , so

= I K = sY K K

K (0) = K 0 > 0

Since we are interested in the evolution of income per capita, it is convenient to rewrite this expression in per capita terms,

Ki =

K = KL LK = K nK = sY K nK = sY ( + n ) K K i i i i i L L L L2

which is the law of motion of per capita capital.

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Econ 620 2013

2.2.1.2. Steady state of the model

In the first chapter we defined a steady state as a situation where the endogenous variables of our model were not changing. In the case of Newtons law of cooling a steady state happens when the temperature of the object is equal to the temperature of its surrounding environment; in the case of the dynamics of the market a steady state is a situation where the price is such that desired supply is equal to desired demand and no further changes in price occur. In the Solow model a steady state is a situation where income per capita (and capital per capita) remains constant12. Combining the law of motion of capital with the production function in per capita terms we obtain the basic equation of the Solow model,

= sK ( + n ) K K i i i
Notice that we have a single differential equation on one variable, Ki . It says that the change in capital per worker is the difference between actual investment and replacement investment. With the labor force growing and depreciation taking place some investment is needed, to provide capital to the new workers that join the labor force and to replace the machines that break down, to prevent capital per capita to fall.

12

In any model we have: Endogenous variables which evolution is determined within the model, like capital or output in this model; Exogenous variables which change over time but according to some law determined outside the model, like population in this model; and Parameters which remain fixed by assumption, n, in this model. Solving any model means describing the behavior of the endogenous variables in terms of the exogenous variables and the parameters.

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Econ 620 2013 When actual investment is larger than replacement investment, capital per capita is growing, when actual investment is less than replacement investment, capital per capita is falling. In this context a steady state is a situation in which that capital per capita is = 0 , and therefore the steady constant, so the economy reaches a steady state when K i state level of capital, denoted by *, must satisfy s ( K i* ) = ( + n ) K i* , so

s K = n +
* i

1 1

Yi = ( K
*

* i

s = n +

Higher savings rate or lower population growth rate are associated with higher income per capita. The steady state of this model fits several of our stylized facts, differences in parameters across countries could potentially explain the crosscountry variation in income per capita, the capital-income ratio and the return to physical capital (the real interest rate) are both constant, but what about the growth rate of output per capita in steady state?

2.2.2. Technological change in the Solow Model

In order to generate growth in output per capita in our model we introduce laboraugmenting technological progress, A ( t ) , modifying our production technology as follows,

Y = K ( AL )

where AL is often known as effective labor. This formulation implies that as the available technology improves, A ( t ) increases, each worker can produce more output with the same level of capital13. Notice that the production function still exhibits constant returns to scale in capital and labor, the private inputs, but increasing returns to scale in the three factors.
13

This type of technological change is known as labor augmenting or Harrod-neutral. Alternatively we could use capital augmenting technological change Y = F ( AK , L ) or Hicks-neutral technological change, Y = AF (K , L ) . Under our Cobb-Douglas assumption the three specifications are consistent with the existence of a steady state. But notice that intuitively if we want an equilibrium where capital and output grow at similar rates (stylized fact 2) and output grows faster than labor (stylized fact 1), then it seems natural to require that technological change takes the form of increases the amount of effective labor. Under this type of technological change the two basic inputs capital and labor (augmented by technology) will grow at the same constant rate. As a result output, a combination of both inputs, will grow at the same constant rate. See Jones and Scrimgeour (2008) for a formal proof.

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Econ 620 2013 As before it will be convenient to re-write the production function in per capita terms,
Y = K ( AL ) Y = LK i A1
1

K = A1 L = LK i A1 L then Yi = K i A1

as before the subscript i denotes per capita variables. Capital and labor follow the same laws of motion than before, and technology is assumed to grow at the exogenous rate, g

= g, A

given A ( 0 ) = A0 A ( t ) = A0e gt

2.2.2.1 Steady State of the model

Using the production function in per capita terms, Yi = K i A1 , we can logdifferentiate it reaching,

=K =K + (1 ) A + (1 ) g Y i i i
the capital accumulation equation,
= sY ( + n ) K = s Y i ( + n ) K K i i i i Ki

(1)

implies that the growth rate of capital is constant if and only if the output-capital Y ratio is a constant, which is consistent with stylized fact #2. Since we want i to be a Ki constant, capital and output both need to grow at the same rate, combining this requirement with (1) we obtain the common (steady state) growth rate of capital, output and technology,
=g =K =A Y i i

This situation is the equivalent to the steady state in a growing economy and is usually called a balanced growth path or stable growth path. Given that along a stable growth path our endogenous variables, Yi and Ki , will be growing at the rate of technological change, it will prove useful for our analysis to rewrite the basic equations in terms of variables that remain constant along the stable growth path, i.e. in terms of variables that achieve a steady state. Defining the following

15

Econ 620 2013

variables in units of effective labor y = function and the law of motion of capital as,

Yi K , k = i , we can rewrite the production A A

Y i = K i A 1 y = k K AK A sY ( + n ) K i K K K i i k = i = g i = i g i = sy ( + n + g ) k 2 A A A A A
These adjusted variables are not of interest in their own right, but rather are a convenient transformation for our analysis14. The variables of interest, per capita and aggregate, can be recovered easily since the level of labor and technology are determined (and known) at any point in time outside of the model. You should become familiar with this type of transformation and you should figure out how to do it in different models. 1 Given our production technology, Y = K ( AL ) , output can grow for 3 reasons: more capital, more labor, more technology. Since the evolutions of labor and technology are determined outside of the model, it is convenient to define new variables that are adjusted for these exogenous changes. In a sense we are reducing the dimensions of our problem, abstracting from the changes on those variables that we know in advance, and concentrating on the endogenous variable. Combining the previous results we reach the basic equation of the Solow model with technological change,

= sk + n + g k k

The intuition is the same than in the previous model. When actual investment is larger than replacement investment, capital per unit of effective labor is growing eventually
14

Technically we have transformed a differential equation that depended on time explicitly

= sK A e gt K i i 0

+ n K i , into an equivalent equation that is autonomous. This allows us to use all

the techniques introduced in the math review.

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Econ 620 2013

= 0 . As before we can calculate the reaching its steady state level, where by definition k steady state levels of output and capital
s k = n + + g
* 1 1

s y = n + + g
*

The steady state growth rate of Yi follows from15 y = The steady state growth rate of Y follows from Yi =

Yi * = n > 0 !! Yi * = Ay * ! ! Y i A

Y * = n + g !! Y * = LYi * ! ! Y L The steady state of this model fits qualitatively all of our stylized facts, differences in the rate of population growth and saving across countries could potentially explain the cross-country variation in income per capita, the capital-income ratio and the return to physical capital (the real interest rate) are both constant, and the growth rate of output per capita is positive, constant and equal to the rate of technological change. Now we turn to analyze what happens when our economy begins out of steady state.

2.2.2.2 Out of the Steady State behavior: Transitional dynamics.

From the basic equation,

k = sk ( + n + g ) k
Since the rate of growth of output per unit of effective labor is proportional to the rate of growth of capital per unit of effective labor nothing is lost by focusing in the behavior of the latter. Dividing both sides by capital per unit of effective labor we reach,

= sk 1 ( + n + g ) k
For low levels of k, its marginal product is very high (recall the Inada conditions) and therefore actual investment (per unit of capital) is larger than replacement investment (per unit of capital) so capital is growing. On the other hand for large levels of k, the marginal product of capital is very low and actual investment (per unit of capital is not enough to compensate for depreciation, population growth and technological change, and therefore capital per unit of effective labor falls.

15

0 Notice that outside the steady state y

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Econ 620 2013

Once we have checked qualitatively the stability, we can turn to a more formal analytical evaluation. Linearizing k around k * , we reach

k s k *

( )

g + n + k k * k k * k t = k * + e t k 0 k *

)(

) (

()

( ()

If the eigenvalue, , is negative, the steady state is stable.

= s k * ( )

( g + n + )

From our steady state relation we know

s k*

( ) = ( g + n + )k

s k*

( )

* = ( g + n + ) s k *

( )

= (g + n + )

And then we can rewrite the eigenvalue as = (1 )( g + n + ) < 0 , and therefore the steady state is stable, as we have already seen in the phase diagram. What are the effects of an increase in the saving rate?

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Econ 620 2013 Since the initial level of capital (associated with the initial saving rate) is below the steady state level of capital associated with the new/higher level of savings, after the increase in saving actual investment is above replacement investment and capital per unit of effective labor begins to increase. As capital increases, its marginal product decreases and each additional unit of capital is translated into smaller increases in output and saving. Eventually the new steady state is reached where the output produced by the last unit of capital provides just enough investment to cover depreciation, technological change and population growth. What happens with consumption? An increase in saving only has temporary growth effects, with the economy returning after a while to the original balanced growth path, along which output per capita grows at the same exogenous rate of technological change, g. Nonetheless the increase in saving has permanent level effect, with output being permanently above the level that would have prevailed at the lower saving rate.

From the previous three graphs some interesting features of the model emerge, 1. No matter where the economy begins eventually achieves a steady state. 2. The further an economy is below its steady state level of capital per unit of effective labor the faster is its rate of growth. The further is an economy above its steady state level of capital per unit of effective labor the faster its capital and output decrease. The key element behind this phenomenon, known as convergence, is the role played by diminishing returns to capital. If capital is low its marginal product is very high and an additional unit of capital is very productive leading to a substantial increase in output, i.e. to high growth. Think of two identical economies one starting from k H ( > k * ) and the other initially in k L

( < k ) . The former will decrease net investment and output (in units of effective
*

labor), the latter will grow, and both of them will eventually converge to k * . 3. Policy changes have no long-run growth effects, only level effects. And therefore the only source of long term growth is the continuous increase in the productivity of labor, which is determined outside of the model. The Solow model highlights two sources of growth; steady state growth (permanent) driven by

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Econ 620 2013 exogenous technological change, and transitional (transitory) driven by endogenous capital accumulation. dynamics growth

So far we have assumed that the saving rate is an exogenous constant, in the next section we are going to allow households to choose how much to save and how much to consume every period. We have seen that the saving rate, together with the rate of population growth, are the two key variables identified by the model as the main sources of variation in income per capita across space and time. Our goal is to evaluate whether the basic predictions of the model are robust in this more realistic environment16

2.2.3. Optimal Saving in the Solow Model: The Ramsey-Cass-Koopmans model.

There are two alternative approaches to present this model. First, a fully decentralized approach. Households own all the inputs of production, they sell labor and capital to the firms and their goal is to maximize their lifetime utility subject to the resources they own. In making their choices they are competitive in the sense that they take the relevant prices, the wage the interest rate and the price of output, as given. Firms hire labor and capital to produce output, which in turn sell to the households and other firms. Their goal is to maximize profits and they are also competitive. Since only relative prices matter we can express the other two prices in terms of the price of output, these prices are determined at the aggregate level, the real wage is determined by the interaction between the overall supply of labor provided by the households and the aggregate labor demand of all the firms in our economy, something similar occurs with the real interest rate. A second approach assumes that economic choices are made by an omniscient social planner, that knowing preferences and technologies does not need markets or prices to allocate resources. Under certain conditions both approaches yield identical results, and therefore when possible we will follow the central planner approach which is simpler. Nonetheless, in the next section we will solve the decentralized problem for expositional purposes.

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A major objection raised against the Solow model is the lack of connection between technological change and investment. In reality, investment is the most common vehicle for introducing new techniques into the production process. Solow (1961) in his vintage capital model modified his framework to allow for embodied technological change, i.e. in order to incorporate technological innovations into the production process you need to replace your capital since technology is embodied in new capital. His results were surprisingly identical to what we have discussed in class. Since technology is embodied in machinery the rate of growth of the economy is determined by the average age of the production facilities, which happens to be constant in steady state. In the case of an increase in saving, this leads to a decrease in the average age of the capital stock. In the vintage model this modernization of the capital stock raises the average level of productivity and the rate of technological change as the economy is moving to the new steady state, once it reaches this point, the growth rate of output and technology remain constant, as in the basic model.

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Econ 620 2013

2.2.3.1 Description of the model. Households

Consider an economy populated by L identical households, indexed by i. Since our households are identical, we can represent their choices as if they were made by a single household, a representative household17. Population grows at the exogenous rate n so

= n, L ( 0 ) = L L L (t ) = L0e nt 0
Lets define C ( t ) as the aggregate consumption at time t of our economy, then

Ci ( t )

C (t ) is consumption per capita. L (t )

Instantaneous preferences of one of these (identical) agents are well represented by the Constant Relative Risk Aversion (CRRA) utility function,

u ( Ci ( t ) )

(C (t )) =
i

>0

uc > 0, ucc < 0 lim uc = 0, lim uc =

c

where , the coefficient of relative risk aversion or the inverse of the intertemporal elasticity of substitution, is a measure of the degree of curvature of the utility function19. Each household is assumed to live forever and maximizes the present value of intertemporal utility, , given by20
17

18

c 0

Our economy trivially admits a representative agent. In general, if we consider an economy populated by a finite number of (non-identical) households and preferences of each one of them can be represented by an indirect utility function of the form, vi p, y i = ai ( p ) + b ( p ) yi , where i is household specific, then these preferences can be aggregated and represented by those of a representative household with indirect utility

v ( p, y ) =

a ( p ) + b ( p ) y . This is just a re-statement of Gormans Aggregation Theorem. The most

i i i

common class of preferences used in macroeconomics, the Constant Elasticity of Substitution (CES), admits a representative agent. 18 The coefficient of absolute risk aversion, ARA (C ) = U ''(C ) U '(C ) , measures the absolute dollar amount that an consumer is willing to pay to avoid a gamble of a given absolute size. The coefficient of relative risk aversion RRA(C ) = CU ''(C ) U '(C ) determines the fraction of consumption that a consumer is willing to pay to avoid a gamble of a given relative size to consumption. Notice that under constant relative risk aversion curvature is independent of the level of consumption (income or wealth). 19 Risk aversion measures the willingness to smooth consumption across states of nature, and intertemporal substitution measures the willingness to smooth consumption across time. These to features are conceptually different. Nonetheless under our preference specification both are governed by the same parameter. 20 In Romers footnote 1 in page 50 of the 4rth edition, he explains how to move from his notation to the one used in these notes. We can rewrite our discount factor as notes = romer n . In footnote 22 I rewrite

21

Econ 620 2013

= u ( Ci ( t ) )e
0

dt =
0

(C (t ))
i

e t dt

(1 ) g > 0 21

(1)

where is a weighted average of present and future utility, with > 0 the rate of time preference being the weight (measure of impatience). A natural question to ask is whether our infinite life assumption is relevant for the results we will derive given that most individuals we know eventually die. There are two lines of justification for this assumption. First, most people know they are finitelylived although they are not aware of when they will die. A potential way to model the uncertainty surrounding such a process is to introduce a constant probability of death at each point in time in (1). The perpetual youth model22 exactly does that and the behavior of households in that model is identical to the behavior captured by (1). A second justification for our assumption is based on intergenerational altruism. We can imagine that each individual not only derives utility from his own consumption but also from the bequest he leaves to his offspring. The preferences representing households that have a finite life-span but leave bequests to their offspring are also well approximated by23 (1). Per capita assets of household i , ai ( t ) , are in the form of ownership of capital or as loans to other households, which we measure in units of the consumption good (normalized by price of consumption). Since both assets are perfect substitutes, they command the same rate of return, r ( t ) . Households are competitive in the sense that they take the return on assets and the wage rate, W(t), as given. Since we ignore the laborour system of differential equations using this fact and I reach equations (2.24) and (2.25) from the 4rth edition of the book. So both methods yield identical implications for the behavior of the economy. 21 Since along the stable growth path per capita variables will be growing at the exogenous rate of

technological change, g , then

(C e )
* gt 0 0

e t

(C ) dt =
0 * 0

g 1 t

( )
e t

1
the

(C ) e( ( dt = 1
* 0 0

g 1 t

) ) dt . For the

integral to be bounded (1 ) g > 0 is required.

22

As

an

illustration

under

discrete
t =0

time

counterpart

of

(1)

becomes

= U ( C1 ) + U ( C2 ) + 2U ( C3 ) + ... = tU ( Ct ) where

e . Now assume that there is a

probability of death, , and we normalize the utility of someone dead to 0. Then the expected present value of the stream of utility of one of these mortal agents with a subjective discount factor of ' is
2 % # % # % ' = U C0 + ' # $ 1 U C1 + *0& + ' 1 U $ 1 U C2 + *0& + ... = $ ' 1 & U Ct

( )

) ( )

) (

) ( )

t =0

) ( )

which

is isomorphic to , i.e. both problems are structurally identical (and so are their solutions). 23 Now assume that our agent lives for only one period but he cares about his descendent, the utility of an agent born in the first period is 0 = U ( C0 ) + V ( C1 ) in the second period 1 = U ( C1 ) + V ( C2 ) and so forth. Then under the assumption that V ( Ct +1 ) t +1 , we can replace sequentially to find that both problems are again isomorphic.

22

Econ 620 2013 leisure choice we can just normalize each household labor supply to 1. Finally lets assume that the government taxes any income at a constant rate, , and makes per capita lump-sum transfers, Ti . The government balances its budget every period. This is the conventional, though unrealistic, way of introducing taxes, this will allow us to focus on the substitution effects associated with the tax, while the income effect will be absent (since the transfer will offset the tax in terms of income). Under these assumptions, at any point in time household is budget constraint is given by24

i = (1 ) (W + ra i ) C i na i + Ti a
Setting up the Hamiltonian, where i ( t ) is the co-state variable associated with wealth of household i , i.e. its shadow price,

(C (t )) Ha =
i

i e t + i e t (1 ) (W + ra i ) C i na i + Ti a

With the following first order conditions (FOC)

Ci = i

(1)
i i
i

1 r n =

(2)

(1 )(W + ra ) C
i

i (3) na i + Ti = a

along with the transversality condition (TVC),

lim i ai e t = 0
t

(4)

The first FOC equates the marginal utility of consumption to the shadow value of wealth. Since income can be either consumed or accumulated as wealth an optimal allocation requires an additional unit of income to be equally valued in its two alternative uses. The second FOC is the intertemporal allocation condition equating through time the after tax return to wealth (saving), adjusted for population growth, and the return to consumption (a combination of impatience and the change in marginal utility as

24

In per-capita terms a fixed level of wealth now needs to be redistributed among (1+n) members of the household the next period.

23

Econ 620 2013

u i )25. To interpret this second condition lets focus first in = cc c i uc the case where utility is linear. Under linear utility, marginal utility is constant and therefore from (2), is constant. In this case condition (3) states that along an optimal solution the after tax return to capital should be equated to the level of impatience. In a sense the amount of extra per capita consumption you can achieve tomorrow by investing today, the return to saving, ( (1 ) r n ) , is equated to the return associated with

consumption changes,

current consumption, the return on consumption,

( ).

Now when preferences are

concave, there is an additional cost since increasing consumption does not increase utility proportionally, but rather at a decreasing rate (diminishing marginal utility). This last u , that measures the change in curvature of our effect is captured by the term i = cc c i uc utility function. In practice increasing the degree of concavity of the utility function has the same effect than increasing the impatience of our representative agent26. The third is just a restatement of the constraint, while the fourth states that at the end of the planning horizon either wealth should not be valued or should be zero. What are we looking for? The two endogenous variables are Ci and ai , therefore the solution of the household problem amounts to find a system of two differential equations on Ci and ai . We already have one of them, (3). To obtain the other lets log differentiate (1) with respect to time, and replace the result in (2) as follows in (2) = = 1 ( (1 ) r n ) C (1 ) r n = + C C (5) i i i i

(5) is known as the Euler equation and describes the optimal behavior of the growth rate of consumption. If the return to saving (the after tax interest rate adjusted for population growth) is larger than the rate of impatience, it is worth to forgo current consumption, increasing current saving and accumulating wealth, in order to increase future consumption. As a consequence consumption will grow over time.
25

You can also interpret the left-hand side of this condition as the (marginal) benefit of delaying consumption (i.e. what you gain if you save today), while the right-hand side could be interpreted as the (marginal) cost of delaying consumption (i.e. what you loose if you save today). 26 There is a conceptual difference between and . The first captures the fact that the more we consume the lower is the additional satisfaction we obtain from additional consumption (diminishing marginal utility) while the second captures that todays consumption is preferred to tomorrows consumption. In our simple model the only choice is between current and future consumption of a single composite commodity (instead of between different consumption goods in a given period and across time) and therefore both parameters lead to qualitatively similar effects. If you are more impatience, higher , you have a higher taste for current than for future consumption, at the same time if the utility function bends fast (is very concave), high you are willing to sacrifice less current consumption for future consumption at a given interest rate, in a sense you also have a higher taste for current consumption (as long as the economy is converging from below)

24

Econ 620 2013 Given the resource constraint facing each agent, consumption growing is equivalent to low initial consumption. Think of 3 agents that only differ on their degree of impatience, facing the same constraints and owning the same resources, their respective consumption paths will look like,

Firms
There are J identical27 firms indexed by j. Any of those firms hires inputs, labor and capital, combining them with the freely available level of technology to produce final output, according to the familiar Cobb-Douglas specification
Yj = ( K j )

( AL )
j

(6)

Firms are assumed to maximize profits and to behave competitively (pricetakers). At any point in time, the profits of the j -th firm are given by, where everything is normalized by the price of final output (real wage, real interest rate) and capital is assumed to depreciate at a rate, .
j = (K j )

( AL )
j

( r + ) K j WL j

The j -th firm hires labor and capital up to the point where their marginal products are equated to the given market prices,

F FK = r + # # K j j K j F FL # # 1 K j j L j

( ) ( AL )
j

= r

) ( ) ( AL )
j

A =W

27

Since all the firms are identical we can represent the aggregate choices of the supply side of our economy with those of a representative firm. In general, in the absence of production externalities and under competitive markets, any supply side configuration can be represented by a representative firm.

25

Econ 620 2013

Notice that since W , r , , A are given and firms have access to the same production function, all firms choose the same capital-labor ratio, i.e. the same degree of capital intensity (this will be true even if we had firms of different sizes as long as they face the same prices and have access to the same technology, this is just a consequence of the constant returns to scale imposed on the production structure28) If we take the ratio of both first order conditions,

( AL ) (1 ) ( K ) ( AL )
j

(K j )

Lj r + = (1 ) K j W

we get the familiar condition equating the marginal rate of technical substitution (the rate at which the firm needs to substitute labor for capital in order to maintain a constant level of output, the slope of the iso-quant) equated to the relative price of the factors of production the rate at which the market is willing to substitute labor for capital (the slope of the iso-cost lines).

2.2.3.2. Macroeconomic Equilibrium

We began with households choosing consumption taking their wage and return on wealth as given, we continued with firms maximizing profits for given input prices. We can now combine the aggregate behavior of firms (demand of inputs / supply of goods) and the aggregate behavior of households (supply of inputs / demand for goods), to determine those equilibrium prices. Aggregating across firms, K j = JK j =K ,
j

L
j

= JL j = L and29 Y j = JY j = Y ,
j

the equilibrium prices are determined as the marginal product of the aggregate capital stock and the marginal product of the aggregate labor force,

( AL ) W = FL = (1 )( K ) ( AL ) A
In the previous section, we found that each firm hires capital up to the point where its marginal product is equal to the given market price. Now, we determine this market price as the marginal products of the aggregate stocks of labor and capital. Finally these prices are consistent with an aggregate market clearing condition, national income equals national product30, GNI = GNP .
28 29

r + = FK = ( K )

With Cobb-Douglas technology this will be true even under increasing (or decreasing) returns to scale.

JY j = J K j

( ) ( AL j )

= JK j

) ( AJL j )

= (K )

( AL )1

= Y where we use the fact that our

production function is homogeneous of degree 1.

26

Econ 620 2013

1
1

GNI = ( r + ) K + WL = ( K )

( AL )

K + (1 )( K )

( AL )

AL = Y + (1 )Y = Y = GNP

Since the representative household cant be either a net lender or a net borrower (i.e. the average loan is 0) and since all the factors of production are ultimately owned by K the households, then Lai = JK j = K , so ai = = K i the representative agent budget L constraint becomes,

= (1 ) (W + rK ) C nK + T K i i i i i

= LK + LK , Then aggregating across households, K = K i =LK i , then K i i

= L (1 ) (W + rK ) C nK + T + LK = WL + rK C = WL + ( r + ) K K C = Y K C K i i i i i where we used the fact that the government budget is balanced every period, i.e. that taxes raised are equal to lump-sum transfers.
As a result the evolution of the aggregate capital stock is determined by,
i

= ( K ) ( AL )1 K C K
And the evolution of aggregate consumption is determined as,
1 1 1 1 C = Ci + n = (1 ) r n + n C = (1 ) ( K ) ( AL ) n + n

a. The Steady State

Given our previous experience we know it is convenient to rewrite the system in terms of variables that eventually achieve a steady state31. Defining K C Y k ,c ,y we can rewrite our system as AL AL AL

30
31

G stands for gross.

Is it clear why do we need to do this? First notice that is just a convenient transformation of the original system, that eliminates the complications introduced by steady state growth (which is just a constant) allowing for a more clear analysis of the transitional dynamics. Our original variables are easily recovered multiplying the new variables by the amount of population and the level of technology that evolve exogenously through time.

27

Econ 620 2013

=K n g = (K ) k ng = =C c 1

( AL )

K C
1

n g = k 1
1

c ng k

k = k c ( + n + g ) k
1 = c 1 k 1 n g

(1 ) ( ( K ) (

( AL )

n + n n g

(( ) (

(7)

which is a system of differential equations that together with the initial condition k ( 0 ) = k0 and the TVC (which intuitively is equivalent to an initial condition for consumption) fully describe the dynamic evolution of our economy32. Imposing the =0, steady state condition, k = c

1 1 1 * = 0 c 1 k n g = 0 k = n + + g + 1

(( ) (

k = 0 c * = k *

( ) ( + n + g ) k

We can use the tools we developed to evaluate stability of this steady state,
c c 0 1 1 k 2 = k k 1 n g 1

) (

)(

* k =k
c =c *

c c* 0 Det < 0 * ? k k

Saddle path

With the stable (negative) eigenvalue associated with k and the unstable (positive) with c.

= 0 , per capita ( K i , Ci , Yi ) and aggregate variables ( K , C , Y ) are When k = c growing along the Stable Growth Path, at the constant rates g and g + n respectively. That implies that the capital-output ratio, the saving rate and the marginal product of capital are constant along such a path. The real wage is growing at a rate g. So even when saving is endogenous growth in the efficiency of labor is the only source of persistent per capita growth. Notice that Solows initial assumption, a constant saving rate, happens to coincide with the (steady state) outcome of a more realistic environment where households are allowed to choose saving optimally.

32

If we set = = 0 and as we said notes = romer n . Then k becomes k = k c n + g k , which is

c k 1 romer g , which is again equivalent to (2.24). So both approaches yield identical implications for the behavior of the economy.
= becomes c the Cobb-Douglas equivalent to (2.25). And c

((

28

Econ 620 2013

b. Transitional Dynamics.
Now we turn to analyze our economy outside the steady state. For that purpose we will use the phase diagram in the c-k space.
= 0 line The c c c 0 = c 1 k 1 n g = 0 1 k 1 n g = 0 so 0 it is a vertical line c c = 1 1 k 2 < 0 as capital increases consumption decreases. k

(( ) (
(

)(

) (

The k = 0 line

c k = k c ( + g + n ) k = 0 c = k ( + g + n ) k k

= k 1 + g + n
k=0

k = 1 < 0 c

The phase diagram

29

Econ 620 2013

For any given level of k, there is a unique initial level of c that is consistent with stability. Any of the trajectories in the phase diagram satisfies (7), but only the stable arm, i.e. the trajectory that leads to steady state, satisfies the transversality condition. The initial level of capital will be determined by an initial condition, k ( 0 ) = k0 , inherited from the past. Assume that k0 > k *

Given that at any point in time k ( t ) 0 , if the economy begins in a point above the stable arm, for (7) to be satisfied c must be decreasing, although not fast enough to = 0 line, thereafter consumption increases as prevent k from falling, until we cross the c capital continues falling. k falls first due to its low marginal product and later due to high c. Eventually capital has to become negative for (7) to be satisfied (or c must jump to zero, which violates (7)), and therefore that path cannot be optimal. We can rule out all those paths.

30

Econ 620 2013 If the economy starts below the stable arm, consumption is low and to satisfy (7) capital needs to be increasing. This path converges to the intersection of k = 0 line and the horizontal axis, A, that violates the TVC. Intuitively the TVC prevents the agent from leaving anything behind when she dies, at point A consumption is very valuable (it is very low so its marginal utility is very high) and we keep accumulating capital, this behavior does not make sense33. We can conduct the transitional dynamics analysis analytically, find eigenvalues, find the arbitrary constants (the previous analysis allows us to set the constant associated with the unstable eigenvalue equal to zero, i.e. to choose the c ( 0 ) in such a way that the economy is in the stable arm), find measures of the speed of convergence, find the initial response of consumption

c. A decrease in the level of taxes: Permanent vs. Transitory shocks.

As we already know differences in saving behavior, together with variation in the rate of population growth, are the two potential candidates identified by the Solow model as the source for the observed variation in growth rates, both across time and space. This model suggests that countries with high savings and low population growth rates will have higher income per capita, and at least temporarily, will grow faster. Starting from steady state, if the government decreases the tax on capital income34 agents will find optimal to increase the amount of capital they hold, since owning capital has become cheaper or equivalently the after tax return to capital has increased. This
33

Formally, we can use the transversality condition to rule out paths towards A , (1 ) g ]t lim i ai e t = lim Ci K i e t = lim ce gt ke gt e t = lim c ke[ =0
t t t

( ) ( )

, since c is small and Noticing that around is almost constant (we cant say the same about c decreasing and therefore its growth rate might be non-trivial). Then log differentiating, the TVC can be expressed as, + 0 + (1 ) g < 0 c
Using our expression for the rate of growth of consumption evaluated at A , satisfying the transversality condition is equivalent to,

A, k

( or (1 ) ( A
then ( A )
1

(1 ) A 1 n g + (1 ) g = (1 ) A 1 + n + g < 0
1

) ) ) n g > 0

Since the golden rule level of capital satisfies, k GR

( )

= n + g , n, g , > 0 and A > k GR ,

which implies that the

< n + g

and therefore

(1 ) ( A 1 ) n g < 0 ,

transversality condition is not satisfied in A , and we can rule out all the trajectories leading to that point. The last thing we need to check is that the stable arm satisfies the terminal condition, bounded utility + (1 ) g < 0 +k lim c ke(1 ) g t = 0 c + (1 ) g < 0
34

In fact our government taxes both labor and capital income (wages and interest rate), but since the laborleisure choice is not modeled agents are not allowed to respond to changes in labor income taxation, on the other hand since the trade-off between consumption and saving is endogenous our agents will adequate their behavior to changes in the rate of capital taxation.

31

Econ 620 2013 requires an increase in the amount they save, or equivalently a decrease in the rate at which they consume. As a consequence differences in fiscal policy that lead to differences in saving behavior could be at the source of the observed variation in income per capita across countries. In this section we are going to illustrate the difference between the adjustment of our economy to a permanent shock as opposed to a transitory shock (in both cases I will assume that the tax cut is unanticipated, i.e. agents learn about it at the instant that it takes place) c 0 , the Lets begin with a permanent (unanticipated) decrease in taxes. Since k = 0 line will shift after a decrease in the tax rate. Since = 0 the k = 0 line will be c =0 unaffected35. A decrease in taxes increases the steady state level of capital, so the c shifts to the right. When does consumption respond? Consumption responds at the time when the new information, in this case the decrease in taxes, is released. At the time of the shock, agents re-optimize using the new information and they find the new path for consumption based on the new tax. This is the only behavior consistent with the satisfaction of the first order conditions represented by (7). Think of oil prices, when do they change? And why? The same happens with consumption. This implies that a jump can only take place when new information is released, in the absence of new information agents try to smooth consumption (i.e. to have something as close as possible to a constant marginal utility of consumption) and they will avoid expected sudden changes in consumption.

35

It is worth noticing that since our tax is rebated as a lump sum transfer there is no income effect associated with a change in taxes. This income effect is at the root of the Keynesian multiplier after a tax cut, which leads to an increase in consumption as a consequence of the increase in disposable income. In our framework this income effect is not present and we only have a substitution effect, when taxes change the relative price of consumption/saving changes leading to changes in the allocation of resources between consumption and investment.

32

Econ 620 2013 At the lower level of taxes, the initial capital stock is below its steady state level, and therefore its after-tax marginal product is higher than the rate of return on consumption. Under these circumstances households find optimal to substitute current consumption for future consumption (less current-more future) in order to accumulate the now more profitable capital, so they increase saving. The high level of investment leads to a transition along which capital is accumulating. This process leads to progressive increases in output and consumption. With capital being accumulated its marginal product has to be falling, and the incentives to postpone consumption are being reduced. Eventually (ad infinitum) the new steady state will be reached, at that point the after tax marginal product of capital net of depreciation is equated to + n + g , and consumption and capital cease to increase.

A temporary decrease in taxes,

Since the agents populating our economy are forward looking they realize that the potential gains from a temporary tax cut in terms of the additional return earned on

33

Econ 620 2013 capital will last only for a few periods and therefore they do not cut their consumption by as much as they do when the tax cut is permanent.

When the tax rate is back in the originally higher level the economy exactly hits the stable arm corresponding to the initial steady state, after that point capital and consumption decrease until the new steady state is reached. Now we can recover the time paths of any variables of interest; capital, consumption, the interest rate, investment, the wage rate36 In this section we have extended the Solow model to a framework where savings is the result of optimal decisions of the households. Nonetheless the implications of the model are very similar to those of the original Solow model, since in steady state the saving rate is constant. The economy eventually achieves a steady state, there is convergence, policy changes have only level, but not growth, effects and there are two sources of growth: technological change along the balanced growth path and capital accumulation along the transitional dynamics. As a result we will proceed our analysis using the simpler version with exogenous savings since little is lost by doing so.

2.2.3.3 A Digression: The Central Planner Solution

The golden rule level of capital, the level of capital that maximizes the level of steady state consumption is given by ( k GR ) taxes, = 0 , in steady state, ( k * )
1
1

= + n + g . Lets compare the level of

capital achieved by our market solution with this ideal level of capital. Abstracting from
= + n + + g . Given that (1 ) g > 0 then

+ g > g and therefore the steady state level of capital is below the golden rule one37. Is there an alternative allocation that would make our representative agent better off, is the market equilibrium Pareto efficient?
36

See the book for similar analysis of a change in the rate of impatience and in the level of government purchases. 37 The steady state level of capital in this model is known as the modified golden rule level of capital.

34

Econ 620 2013 From the First Welfare Theorem we know that if markets are competitive, complete and there are no externalities or transaction costs (and agents are finite) then the competitive equilibrium is Pareto-efficient. In general Pareto efficiency means that there is not other allocation that reaches a higher value of for at least one agent (always satisfying the constraint), without lowering the value of for other agent (in principle the market will allow for all those welfare improving reallocations to take place in the form of trade). From our analysis of the Solow model, if the economy was above k GR , you can reduce capital and increase both current and future consumption. The situation is different when the initial level of capital is below k GR , in that case you can only increase future consumption and the cost of current consumption. With endogenous saving, the steady-state level of capital is reduced by a factor that reflects the fact that present consumption is preferred to future consumption (impatience)38. Even if you begin with k= k GR , the economy will converge to k * (because impatient agents with this high level of capital will find optimal to consume at an unsustainable high rate decreasing capital until the modified golden rule is reached). An alternative way to inspect the efficiency of our solution is to solve the problem from the perspective of a benevolent central planner (which is always the efficient solution). He knows preferences of the households and the production technology available for the firms. To maximize social welfare he allocates the resources without the need of a price system. The problem he faces differs in the fact that he takes into account that w and r are functions of the capital-labor ratio, as opposed to the decentralized/competitive problem where households and firms took them as given. The planner has to choose the paths for per capita consumption and capital to solve,

max = max u ( Ci )e t dt = max

0 0

(Ci ) (c )

1
1

e t dt = max
0

( cA e )
gt 0

e t dt =

max A0
0

(c )

(1 ) g t

dt = max
0

e 't dt

Subject to

k0 given
k (t ) , c (t ) 0

And the law of motion of capital that is also a market clearing condition, that states that all output should be either consumed or saved, k = k c + n + g k

( )

Setting the Hamiltonian,

38

g picks the fact that tomorrows MU of consumption will be reduced due to the growth of consumption

at the rate g.

35

Econ 620 2013

(c ) Ha =
The FOC are

e ' t + e ' t ( k ) c ( + n + g ) k k

c =

(1)

(k )

n g = '

(2)

along with the transversality condition and the constraint,

lim ke 't = 0
t

As before, it is helpful now to think at this point on what are we looking for? The evolution of this economy is determined by the paths of the 3 inputs (capital, technology and population), output and consumption. Given the 3 inputs, the evolution of output is straight-forward. Since population and technology are exogenous, the first thing we need is the path for capital. Therefore we are looking for the paths of capital and consumption. Knowing that, we need to think on how to transform our conditions to reach a system on those two variables. Log diff (1) and replacing in (2) to get rid of

(k )
1

= n g = '+ c c

1 k

( )

n g + 1 g '

= c

the behavior of the competitive economy (in the absence of taxes). Since, under the assumptions need for the First Welfare Theorem to hold, it is equivalent to solve the competitive problem or the central planners problem, we can choose which solution method to follow.

( ( k )

n g

which are identical to the dynamic equation describing

36

Econ 620 2013

2.2.4. Evaluation of the Neoclassical Growth Model

One of the most interesting features of the Solow model is the amount of testable implications that it generates. In this section we are going to evaluate the implications of the model along several dimensions.

2.2.4.1. The Solow Model and Kaldors stylized facts.

1. Per capita output growth at a positive rate which shows no tendency to diminish. Once we allow for exogenous technological change, output per capita grows permanently at a constant and positive rate that coincides with the exogenous rate of technological change. 2. The capital-output ratio shows no trend. In steady state output and capital grow at the exogenous rate of technological change and therefore the capitaloutput ratio is constant. 3. The return to physical capital shows no trend. The marginal product of capital, Y K , is constant in steady state. 4. A wide variety of growth rates and income levels. The Solow model provides a trivial, non-informative, way to account for differences in growth that relies in differences in the non-modeled rate of technological progress across countries. A second mechanism is related to the convergence properties of the model, with countries away from steady state growing faster than countries close to steady state. When we turn to differences in the levels of output, since Yi * K i*

( )

A1 , the Solow

model points to differences in capital per capita as the source of cross country variation in income per capita. Countries where workers are equipped with more capital will have higher income per capita.
45,000 40,000 35,000 30,000 25,000 20,000 15,000 10,000 5,000 0 0 20,000 40,000 60,000 Ki 80,000 100,000 120,000

Correlation: 0.94

Yi

37

Econ 620 2013 The obvious next step is to evaluate the determinants of capital suggested by the

s model using the fact that Yi = A ( k ) = A . According to the Solow n + + g model differences in capital per capita stem from differences in savings and population growth, and therefore the ultimate determinants of the international variety of income levels are those two variables.
* *

45,000 40,000 35,000 30,000 Yi 20,000 15,000 10,000 5,000 0 0.00% 10.00% 20.00% 30.00% 40.00% Saving
Yi

45,000 40,000 35,000 30,000 25,000 20,000 15,000 10,000 5,000 0 -1.0% 0.0% 1.0% 2.0% 3.0% 4.0% 5.0% n

25,000

Correlation: 0.69

Correlation: -0.3

So far a relatively simple model seems to do an outstanding job at capturing key features of growing economies.

2.2.4.2 Convergence.
In general we define convergence as the tendency for countries with lower initial income to grow faster and catch up with higher income countries. The Solow model predicts that the farther an economy is from its own steady state the fastest will be its rate of growth. This is just a consequence of the key role played by capital in this model combined with a production technology that exhibits diminishing returns to this input. As a result in countries with low levels of capital (which also have low levels of income), an additional unit of capital is very productive leading to a substantial increase in output, i.e. to higher growth. Lets turn to data on OECD (as Baumol (1986)) countries to check the validity of this prediction.

38

Econ 620 2013

OECD Convergence
Average Growth 60-97 5.00% 4.00% 3.00% 2.00% 1.00% 0.00% 0 5 10 15 Yi 1960 20 25 30
Thousands

The data seems pretty consistent with the predictions of the model. Countries that were already rich in 1950 tend to grow slower than countries that were poorer at that date. Convergence allowed those relatively poor countries to catch up with the leading ones. When the same prediction is checked against a broader data-set that includes not only high income countries but also middle and low income ones, the signs of convergence disappear.

Convergence
7.00% 6.00% 5.00% 4.00% 3.00% 2.00% 1.00% 0.00% -1.00% 0 -2.00% -3.00% Average Growth 60-97

10

15 Yi 1960

20

25

30
Thousands

The problem is that the sample of countries in our first exercise is not random, only successful countries, the ones that meet the requirements to become part of the OECD, were included and therefore is not surprising to find convergence, since those countries are rich nowadays wherever they began in 1950. Once we use the whole population of countries the evidence of convergence disappears.

39

Econ 620 2013 But there is still a potential solution to this problem. If you were a zoologist researching on the relation between age and height and you had a mixed sample of mice (the height of an adult mouse is a few centimeters) and elephants (the height of an adult elephant is several meters), you will end up finding no relation between height and age39. You will have adults very tall (elephants), adults very short (mice), youngsters very short (mice) and youngsters relatively tall (elephants). This is something similar to what might be happening in the previous figure, we are mixing elephants and mice. What is the solution? For the zoologist it is evident and straight forward, normalize the height of each of the animals by the adult (steady state) height of its species, and then conduct the analysis, you will find that there is a positive relation between height and age (at least for a certain age interval). Similarly, the Solow model implies that (only) if countries share the same steadystate (if they are the same species) they will convergence to the same level of income and thereafter all of them will grow at the exogenous rate of technological change, g. Nonetheless the model allows the steady state to vary with n and s, which exhibit substantial variability across countries. We can then talk about conditional convergence40, i.e. the Solow model predicts that countries will catch up only after controlling for the determinants of the steady state. In a sense we are going to have to normalize the income of each country by its steady state income (which is related to its saving rate and its rate of population growth). Formally convergence could be tested using the following equation,

ln yt ln y0 = ln y* 1 e t ln y0 1 e t

( 1) ( + n + g ) < 0

is often referred as the speed of convergence, and is a measure of the rate at

which economies move towards their steady states. Given that 1 et is positive (since

< 0 ), this equation implies that the growth rate between 0 and t ( ln y ( t ) ln y ( 0 ) ) is positively correlated with the steady state level of income and negatively correlated with the initial level of income. What is even more important we can empirically measure it, having information on growth rates, initial and steady state levels of income41.
A first set of regressions, which are the econometric equivalent to the last graph, tested for absolute convergence, i.e. they did not control for the steady state. These results are from Mankiw, Romer and Weil (1992).

= 0.00017 ln yt ln y0 = ln y0 1 e t

(0.00218)

And as we expected from the graph, they found no signs of convergence.

39

For the sake of exposition, I am assuming that both species have similar life spans, even though I have never heard of a 70 year-old mouse. 40 If convergence was absolute, then independently of their steady states, lagging countries will grow faster than leading ones. 41 See the Appendix for a formal derivation.

40

Econ 620 2013 Barro and Sala-i-Martin (1995) conduct this same type of regressions for economic areas that most likely share the same steady states (this is an alternative way to control for the steady state, choose a sample that most likely shares the same = 0.0279 ( 0.0033) , steady state). Looking at Japanese prefectures they find = 0.0174 ( 0.0026 ) , looking at convergence between states in the U.S. they find

= 0.019 ( 0.002 ) . looking at European regions they find

Annual growth rate vs. log per capita personal income for U.S. states.

A second set of regressions tested for conditional convergence, i.e. they did control for the country specific determinants of the steady state.
y = 0.013 ln t = ln y* 1 e t ln y0 1 e t y 0

(0.004)

1 s where y = + n + g
*

The results are more supportive of the model, the convergence parameter has the right sign and it is statistically significative, although from an economic point of view is very small, i.e. convergence takes place but a very slow speed. For instance, imagine two countries Rich and Poor that share the same steady state, and the income of Rich is twice as much as the income of Poor. At the estimated rate of convergence it will take Poor around 53 years to reach an income equal to 75% of the income of Rich and around 106 years to reach an income level of 87.5% of the income of Rich.

41

Econ 620 2013 To summarize our findings, during the last 50 years we have not observed a tendency for economies to converge, in fact the standard deviation of income per capita between 1960 and 1997 for our sample of countries more than doubled, increasing from 5,595 to 11,584 (take a look at Pritchett, L. (1997) Divergence, Big Time, for a different view on the lack of convergence). When we look at economies that have similar underlying parameters and therefore similar steady states, like US states, Japanese Prefectures or European regions, we find that the initial level of income plays an important role in explaining the subsequent growth performance; areas with low initial incomes tend to grow faster reducing their distance to the leaders. Once we control for the determinants of the steady state (specifically, investment in physical and population growth) we recover some signs of convergence, what the literature calls conditional convergence, i.e. the fact that economies that are further from their respective steady states tend to move towards those steady states taking larger steps. In general the estimates of the speed of convergence are low, in the range of 1%2%, that implies that in one year the economy reduces by 1%-2% the distance to its own steady state, and it takes between 35 and 70 years to eliminate half of the initial gap42. Overall the reported evidence on convergence tends to lean (weakly) towards models that stress the role diminishing returns to capital.

2.2.4.3. Case Studies. a. The reconstruction of Europe after WWII: An economy after a large destruction of capital.
Wars can be used as natural experiments to test the implications of economic theory. The following example uses data from post-war Europe to evaluate the performance of the Solow model. France Germany 5,406 2,217 41% 70%

Italy
3,521 1,922 54% 75-80%

Austria 4,096 1,725 42% 70%

Holland 5,544 2,686 48% 60-73%

Y 39 Y 45 46 Y 45 Y 39
K
45

4,793 2,573 53% 65-80%

39

Table 1. European output and capital stock before and after WWII.

Country France

Casualties Population Armed Forces Military Civilian %Milit. %Civil Tot.% 42,000 4,600 122 470 2.65% 1.26% 1.41%

42

e t y y* =

(y y ) t = ln 2 t = .69 t = .69
*

42

Econ 620 2013 Italy Netherlands Germany/Austria U.S. Canada Australia 43,800 8,700 78,000 129,200 11,100 6,900 227 14 3,250 405 39 29 60 0.14% 0.66% 150 3.43% 1.81% 1.88% 2,350 18.16% 3.91% 7.18% 2.48% 0.00% 0.31% 3.57% 0.00% 0.35% 2.19% 0.00% 0.43%

400 17,900 16,354 1,100 1,340

Table 2. The effects of the war in European population. Figures in thousands, population measured in 1940.

The data suggests that our group of European nations suffered an important reduction in capital per capita as a consequence of the war. The next figure graphs the average growth of per capita GDP in the post-war period,
10.5 10

9% 8% 7%
C anada

9.5 9 8.5 G ermany 8 7.5 France

6% 5% 4% 3%

1948

1951

1954

1957

1960

1963

1966

1969

Log Output per capita

Post World War II per worker growth (war economies).

This behavior is broadly consistent with the transitional dynamics generated by the Solow model. Low capital, relative to its steady state level, will lead to a period of high and decreasing growth.

b. South Korea and the Philippines: An economy after a large increase in saving.
South Korea and the Philippines were similar countries in 1970. They have similar levels of income per capita, roughly equal to $1000, a similar population, age structure and labor force, a similar allocation of resources between sectors with most of their population working in the agricultural sector, similar geographical location, similar (low) levels of college attendance, but very different experiences thereafter and very different saving rates. Over the following 35 years Korean income per capita become 8 times larger than Philippines one.

43

Econ 620 2013

Again as the Solow model predicts, a large increase in the saving rate, like the one experienced by South Korea economies in the 60s, will be followed by a period of high (but decreasing) growth.

2.2.4.4. Quantitative Implications.

At the qualitative level the predictions of Solow model seem to be consistent with Kaldors stylized facts, data about cross-country income differences, differences in growth rates and some recent growth episodes. Nonetheless we are going to push the model one step further, evaluating its ability to reproduce the quantitative features we have just described. In order to evaluate the quantitative implications of our model we will begin by pinning down some of the key parameters from the data.

Labor income share: Time series and cross-country. Sources: Jones (2008) and Gollin (2002)

44

Econ 620 2013

Parameter

43 g s n

Value 1/3 0.05 0.02 Country specific Country specific

Source Gollin (2002) Mankiw (1995) PWT PWT

a. Cross-country variation of output per capita.

Lets take two countries with a 20-fold income gap in 1997, for instance Canada ($35,281) and Gambia ($1,633). This twenty-fold gap in income per capita implies that

K A K Yic ( K ic ) ( Ac ) K Ac = Ag = = ic c = 20 ic = 20 ic = 201/ = 8,000 1 assume Yig ( K ) ( A ) K ig K ig Ag K ig ig g Using the same data source we can calculate the ratio of the average per capita capital for the two countries reaching 121. Since capital is a minor ingredient in the production of output (only 1/3), explaining the large variation in income per capita on the basis of variations in capital per capita requires a huge spread in the distribution of this variable, which is almost two orders of magnitude higher than the observed in the data. Assuming the economies are in steady state, we can translate the observed differences in income per capita into implied differences in saving rates or population growth rates44. When we do this exercise we obtain differences in the order of 400, i.e. in order to explain the observed difference in output per capita an average Canadian must have a saving rate around 400 times larger than the saving rate of an average Gambian. In our data set savings in Canada are around 24.6% less than 3 times larger than the 8.5% savings reported for Gambia. Another way of looking at the problem is to calculate the implied differences in returns to capital.
1 1 1 1 y rg ( k g ) k Y A A Y g ig g ( g ) Ac = Ag g ic = 400 = = = = = 20 ( ) 1 assume rc ( kc ) 1 kc Y A A Y ic c c ig ( yc ) The model implies huge differences in the returns to capital required to explain the observed variability across time or across countries in income per capita. Measuring returns to capital tends to be difficult, you can only look at companies that are quoted in stock markets or government bonds45, but in a world with some capital mobility the

43

Since the Solow model assumes perfectly competitive markets the elasticity of output to capital coincides with the capital share in national income, which can be recovered from the data. 44 In the case of population I assumed away the effects of capital depreciation. 45 See Caselli and Feyrer (2007) for different approaches to measure the marginal product of capital. Their preferred measure, which adjusts for natural resources (natural capital) and relative price differences between consumption and investment goods, exhibits very small variation across countries.

45

Econ 620 2013 suggested differences in rates of return will lead to huge capital flows from rich to poor countries, but in 1990, the richest 20% of the world received 92% of the portfolio capital inflows; the poorest 20% only received 0.1%. The riches 20% of the world population received 79% of FDI; the poorest 20% received 0.7% of FDI. It seems that capital is flowing in the other direction. What can we conclude from the previous calculations? If the share of capital in national income is a good measure of the elasticity of output to capital ( ) (i.e. if markets are competitive and there are no externalities), then since capital is a relatively unimportant input of production the observed variation in the level (growth rate) of capital per capita cannot account for the observed variation in the level (growth rate) of income per capita across countries in the world.

b. Quantitative effects of a destruction of capital.

We can quantify the effects of a 50% destruction of capital in the growth rate of an economy that is moving along a stable growth path, lets assume a saving rate of 20% (this is roughly the average saving rate of continental European countries over the last half century),

= k y = k y k k = sk n + g + k % k = sk 1 n + g +

= g + k = g + sk 1 ( n + g + ) Y i = Ay Yi = g + y

= g + sk 1 ( n + g + ) Y i

As you can see the previous formula captures the two elements of growth in the Solow model, steady state growth and transitional dynamic growth. Using parameter values consistent with post-war European data46 this exercise generates a growth rate of per capita income close to 3.5%, of which 2% corresponds to the exogenous rate of technological change and the remaining 1.5% to the transitional dynamics generated by the destruction of capital. This figure is only half of the growth rate observed in postwar Europe.

c. Quantitative effects of an increase in the saving rate

1 * k in the formula for per capita 2 growth, as the initial capital stock, and trace the evolution of the capital stock, output and their growth rates.
46

Given n, g , , and s , we can calculate

k * . Then we can plug

46

Econ 620 2013 In order to get a sense of the quantitative relevance of changes in saving on subsequent growth lets analyze the effects in steady state income per capita of a change in the savings rate,
*

y = k

( )

1 1 s y* s = = s 1 n + g + n + g +
/

1 n + g +

It is convenient to rewrite it as an elasticity

/ / 1 y * s s 1 s y * s = = = 0.5 = 0.5 * * * s y 1 n + g + n + g + y 1 s y / 1

So changes in savings lead to relatively small changes in steady state output. Revisiting the growth performance of South Korea the Solow model predicts that after doubling their saving rate, steady state income per capita will increase only by 50%, while their growth experiences are characterized by a doubling of income per capita every 7-10 years, well above the predictions of the model47.

d. Growth Accounting
Solow (1957) provides a model free framework to empirically investigate the contribution of different inputs to growth, this type of exercise is generally known as growth accounting. For simplicity assume the following production function, where technological change is Hicks neutral,
Y = AF [K , L ]

Taking time differentials and dividing by Y

Y Y Y A K L A K L + Y K K + Y L L (1) + K + L Y = + + Y = A A K L Y Y Y K Y K L Y L K L Y = A +K K +LL
where (1) assumes that markets are competitive and therefore factors are paid their Y K marginal products. Under this assumption is the capital income share, which we K Y

47

Average Canadian GDP for year 2004 (base year 2002) is in the order of CAN$40,000. Canadas saving rate is around 20%, notice that an increase in saving of two percentage points will bring a (permanent) increase in average income per capita of CAN$ 2,000. Since this difference grows forever at the exogenous rate of technological change, it seems ridiculous to regard the effects of such a policy as unimportant.

47

Econ 620 2013

Y L is the labor income share, which we denote as L . Since both L Y shares need to add up to one, we can rewrite the previous expression as,
denote as K and

+ K + K =A + (1 ) L =A Y Y K K i K i

( )

This equation decomposes the increase in output per capita into two components: increases in productivity, and increases in capital per capita, i.e. capital deepening. Since we can observe the rate of growth of output and the rate of growth of capital we can rearrange the previous expression to estimate the increase in productivity as

=Y K A i K i

( )

is the rate of growth of technology, the rate of growth of Total Factor A Productivity or the Solow residual. It captures everything that contributes to growth in income per capita that is not capital, and to some extent is a measure of our ignorance. Solow (1957) took time series of output per unit of labor, capital per unit of labor and the capital share for the U.S. from 1909 to 1949, he found that only 1/8 of the increase in output per capita was a consequence of capital deepening. Using US data from 1950 to 2000, and assuming a constant capital income share of one third, we reproduce Solows calculations for this new sample period,
Y
Y i

K i

Contrib. to of K i Y
i

Contrib. to of A Y i 67% 27% 70%

1950-1973 1974-1990 1991-2000

4.0% 2.7% 4.2%

3.0% 0.9% 3.0%

3% 2% 2.7%

2% 0.24% 2.1%

33% 73% 30%

I have chosen somewhat arbitrary break-points, but we can see that the last 50 years of US growth could be divided into 3 periods: (i) post WWII characterized by high productivity growth and strong capital deepening, with the capital-labor ratio growing at 3% and productivity growing at a rate close to 2%, (ii) the productivity slowdown period 1973-1990, during which the capital-labor ratio grew at the slower rate of 2% per year and productivity almost remained constant; and (iii) the last ten years of the past century, with again high productivity growth and high capital deepening. The observed fluctuations in the rate of capital deepening are important, but more important than that is the degree of change in total factor productivity growth; the swings in this variable over the three periods are huge. The contribution of the Solow residual to per capita growth exhibits great variation, from 27% of the observed growth during the productivity slowdown to 70% in the late nineties.

48

Econ 620 2013

2.2.4.5. Conclusion.
Robert Solow, in his 1956 and 1957, articles was mainly concerned with the growth process of a mature capitalist economy, the U.S. All the emphasis was placed in capital accumulation as the main engine behind growth and his results were striking; in the presence of diminishing returns to capital, capital accumulation cannot be the ultimate source of long run growth. In a sense capital accumulation is not the source of growth but rather growth in itself. Given the limited role played by capital in the production of output, observed variations in capital across countries or in the same country across time are insufficient to explain the variations in income across countries or over time. As a result Solow pointed to technological change48 as the driving force behind the sustained increase in income per capita experienced by capitalist economies, and therefore differences in technological level could be at the root of the cross country differences in income per capita. Even if this simple version of the neoclassical model was able to match quantitatively the data, it still would leave important questions unanswered. If differences in income levels and growth rates where the consequence of differences in saving choices and population dynamics we still need a theory to understand what causes those differences, we will need models of savings (we already presented one) and fertility choices to account for those differences.

48

Notice that differences in technology are; first, more difficult to measure since by technology we mean ideas, methods of production, institutions i.e. anything that affects production and is not capital or labor and second, it is difficult to understand what prevents the best ideas or methods of production to be used across the world. When I use a pencil you cannot use it at the same time, but when I use a mathematical formula you can be using it at the same time, without affecting my use of it (ideas are non rival, we will return to this point shortly).

49

Econ 620 2013

2.3 Endogenous Growth Theory

If we are interested in the sources of long run growth, neoclassical models provide a negative answer, specifically if markets are competitive and there are no externalities (i.e. the share of national income paid to capital is a good proxy for the contribution of capital to output) then physical capital accumulation cannot account for a large part of either long-run growth or cross-country income differences. The main source of longrun growth, the rate of technological progress, was assumed to be exogenous and therefore determined outside the model. A group of growth theorists led by Paul Romer (1986) began to develop a class of models in which the rate of technological progress is the result of intended/unintended actions of the agents populating the economy, this stream of literature received the name of endogenous growth theory. In the absence of exogenous technological change, the standard neoclassical model achieved a steady state along which per capita variables did not grow. The diminishing returns to capital that characterize Solows technology imply that as capital accumulates its marginal product (its additional contribution to output) decreases. This continuous decrease in the marginal product of capital eventually leads to a situation where investment is just enough to cover depreciation and provide enough capital for the new born workers as a result growth ceases. This result was robust to changes in the demand side of the economy, and therefore changes in our modeling strategy for the supply side of the economy, the production technology, seem the most promising avenue. A common feature of all the models in the new growth literature is the fact that the marginal product of capital (defined in a broad sense to include both physical, human, organizational) remains bounded above zero. As we will see the elimination of diminishing returns opens the possibility for per capita growth even in the absence of exogenous technological change. In the following section we will introduce a rather rudimentary technology, aK , to illustrate the behavior of the economy under constant returns to scale for the reproducible factors. Then we will briefly present some of the alternative production structures introduced in the endogenous growth literature and finally we will explore an endogenous growth model with human capital.

2.3.1. A model with Constant Returns to Scale in reproducible factors.

The key property of endogenous-growth models is the absence of diminishing returns to capital at the aggregate level. The simplest version of a production function with the marginal product of capital bounded above zero is a technology where output is linear in capital
Y = aK

(1)

Where a is a positive constant that reflects the level of technology, and that in a fully fledge model is endogenously determined. Notice that (1) violates the Inada conditions.

50

Econ 620 2013 Final output can be consumed or invested (saved). The fraction of output devoted to investment, s, is exogenous and constant, so

= I K = sY K K

K (0) = K 0 > 0

Rewriting the model in per capita terms, and assuming that population grows at an exogenous rate, n, we obtain the following differential equation for the evolution of the per capita capital stock,

Yi = aK i = sY + n K K i i i

= saK ( + n ) K K i i i

(2)

= sa ( + n ) K i
, given that consumption is a =K =C Since Yi is proportional to Ki , then Y i i i fixed proportion (1-s) of output. Furthermore since (1) is a linear differential equation on Ki we can find the paths that the capital stock (and output and consumption) will follow,
aggregate K i ( t ) = K i 0 e( sa n )t K ( t ) = L (t ) K i (t ) = L0e nt K i 0e( sa n )t = K 0e( sa )t

Using a diagram similar to the one we used for the Solow model, under the assumption that sa > + n

From this analysis we can see that the economy does not achieve a steady state, since there is permanent per capita growth. Nonetheless we can use a similar definition of equilibrium. In this model, we consider equilibrium to be a solution where the growth rate is constant, and instead of steady-state we refer to it as a stable growth path (as we did with the Solow model with exogenous technological change).

2.3.2. Alternative Specifications of the aK technology.

51

Econ 620 2013

Arrow (1962) and Lucas (1988) present a model where learning-by-doing leads to technological change as an accidental by-product of the economic activity. Lets assume population is constant. We can model the level of technology as an increasing function of the aggregate level of capital,
A ( t ) = BK ( t )

There are J identical firms indexed by j. Any of those firms hires inputs, labor and capital combining them with the freely available level of technology to produce final output, according to the familiar Cobb-Douglas specification
Yj = ( K j )

( AL )
j

Each firm, being just one of many, ignores its individual contribution to the accumulation of knowledge (this is an externality), taking the evolution of A as exogenous49. As you can see in the aggregate we have a technology that exhibits constant returns to capital, summing across firms,

K
j

= JK j =K ,

L
j

= JL j = L

1 j

so Y = Y j = JY j = J K j
j

( ) ( AL )

= (K )

( AL )

= ( K ) ( BKL )

= aK

Along similar lines, Barro (1990) emphasizes the importance of the government provision of public infrastructure. Assuming a constant labor force, in his set up output is produced combining capital, labor and a non-rival publicly available good, G , according to the following technology,
Y j = ( K j ) ( GL j )

The government devotes a constant fraction of output, Y , to the provision of infrastructure. Summing across firms

Y = Y j = JY j = J ( K j ) ( GL j )
j

= ( K ) (GL )

That combined with the fact that G = Y yields,

Y = ( K ) ( YL )

Y = ( K ) ( L )

Y = ( L )

K = aK

49

See the next footnote for a rationalization of this behavior.

52

Econ 620 2013 In this type of models the marginal product of capital is bounded above a positive number. As a consequence of this any policy that affects either saving or the marginal product of capital will have permanent growth effects. In contrast with Solow type models, as capital accumulates, its marginal product tends to zero, so any policy will have only temporary effects. Policies that induce changes in the allocation of resources to the activity that causes technological change will have permanent effects on the growth rate of the economy.

As we can see from the graph, higher saving lead to a permanently higher rate of growth. The transmission mechanism is simple a higher level of saving implies higher investment, and a higher accumulation of knowledge, and higher growth. A final important issue with this type of models concerns the optimality of the market solution. In the presence of externalities50 the First Welfare Theorem no longer holds since there is a gap between the private marginal product of capital ( 1 1 ( K ) ( KL ) = a in the learning by doing model) and the social marginal product of capital ( ( K ) ( KL ) = a in the same model). This is just a consequence of the external effect, firms when making their investment decisions do not take into account the (negligible) effect of their individual decisions in the aggregate capital stock and in the expansion of knowledge and therefore they invest below the social optimum.
1
1

2.3.3 An Endogenous Growth Model with Human Capital

50

Irwin and Klenow (1994) estimate learning rates (the decrease in marginal cost of production every time a firm doubles output) using firm-level data on seven generations of RAM semiconductors over 1974-92 they find learning rates that average 20%. Furthermore they also report that firms learn 3 times more from an additional unit of their own cumulative production than from an additional unit of another firms (in the same industry) cumulative production. However, the industry cumulative production is typically more than three times any given firms cumulative production, this means that the absolute contribution of industry-wide cumulative production to each firms learning outweights the absolute contribution of its own cumulative production. Under these circumstances seems sensible to assume that firms ignore the impact of their individual choices in the evolution of total factor productivity, since the main beneficiaries of those choices are other firms.

53

Econ 620 2013

The neoclassical growth model is at the same time a remarkable success and a remarkable failure. The success is, of course, that the model is able to account for each and every one of the stylized facts of growth in developed countries. In all appearance, the model captures some key characteristics of the actual economic system of advanced industrial countries. For this reason, the neoclassical growth model is the underlying structure used for most macroeconomic research concerning developed countries. The neoclassical growth model is also a failure, however, because it does not provide any explanation for the lack of convergence between rich and poor countries during the last 50 years. Evidently, there is something that keeps most of the world from growing, and whatever is it, it is not captured in the neoclassical growth model. The question arises whether we need to abandon the standard growth model completely in order to understand stagnation in developing countries. In this section, we will see that it is possible to extend the standard model in a way that keeps all its implications for rich countries intact, while also offering an explanation for stagnation in the poorer countries of the world. The key ingredient for this explanation is the endogenous growth driven by the accumulation of both physical and human capital. This possibility is empirically relevant since the correlation between the average years of schooling and per capita GDP is close to 0.85. The following graph plots per capita GDP for 1997 against the average years of schooling for our sample of countries,
45,000 40,000 35,000 30,000 25,000 20,000 15,000 10,000 5,000 0 0 2 4 6 8 10 12 14

Yi

Years of Schooling

As we can see more educated countries tend to enjoy higher income per capita, and therefore at some point higher growth (or alternatively we could think that richer countries devote more time to education).

2.3.3.1 Description
Since endogenous savings seems not to play a crucial role in the results of our analysis, we will summarize the demand side of our economy by an exogenously given saving rate, s, and therefore each period a fixed proportion of output is saved/invested. In the supply side we need to specify, c) The production technology for final output. d) The law of motion for physical capital. 54

Econ 620 2013 e) The production technology for human capital and its law of motion. - The production function for final output. As before our economy produces an homogeneous good, Y ( t ) , combining capital, K ( t ) , skilled labor, H ( t ) h ( t ) L ( t ) , and labor augmenting technology, A ( t ) , according to the following Cobb-Douglas technology,

Y = K ( uhLA )

Our formulation of H implies that a worker with human capital51 h is the productive 1 equivalent of two workers with h each, or a half-time worker with 2h . Finally since 2 the accumulation of human capital requires our representative agent to spend time at school, we denote by u the fraction of time devoted to the production of output. We assume that this time allocation is exogenous and constant with the remaining time being devoted to the acquisition of skills. - The law of motion for physical capital. As in the previous models the labor force is assumed to evolve exogenously at the exponential rate

= n, given L ( 0 ) = L L L ( t ) = L0e nt 0
Technology is assumed to grow at the exogenous rate, g A
= g , given A ( 0 ) = A A ( t ) = A0e g At A 0 A

Final output can be consumed or invested (saved). The fraction of output devoted to investment, s, is exogenous and constant, and the existing physical capital stock depreciates at a rate , so

= I K = sY K K

K (0) = K 0 > 0

- The production function for human capital and its law of motion. The production technology for (per capita) human capital takes a different form. Unlike physical capital, human capital is not just a part of output that gets converted into
51

Notice that H is an aggregate measure of human capital and h is the average measure of human capital of the population. In the last section of this chapter we will see how can we map the data on years of schooling with our measure of human capital.

55

Econ 620 2013 productive capital. Rather, producing new human capital requires the use of existing human capital and time. Human capital is produced through education (and experience), and existing knowledge is the key ingredient in the production of education. We therefore assume that future human capital is produced using only human, but not physical, capital52. The amount of future human capital depends on the fraction of time, 1 u , spent on education and on the current level of human capital

h = B (1 u ) h

(1)

Lucas (1988) points out that this production function is consistent with the evidence we have on individual earnings. In our formulation B is a measure of the overall productivity of the educational sector. Notice that if no effort is devoted to the accumulation of human capital, then none accumulates and per capita human capital remains stationary at its initial level.

2.3.3.2 Steady State of the model

The evolution of per capita human capital is easy to determine from its law of motion, dividing both sides by h we reach,

h = h = B (1 u ) g h h
To analyze the steady state of our model, it is once again useful to rewrite the model in terms of variables that will achieve a steady state. Since labor, per capita human capital and technology grow at known rates, we can infer that a transformed variable that would satisfy this condition (stationary) takes the form,

X (t ) , where X = K , Y , C A (t ) h (t ) L (t )

Using our newly defined variables, the production function and the law of motion of physical capital become,

A (t ) h (t ) L (t )

Y (t )

K (t ) uh (t ) L (t ) A (t )

A (t ) h (t ) L (t )

y = k u 1

g g n = s Y ( + g + g + n ) k = K k = sy ( + g A + g h + n ) k A h A h K
52

Mulligan and Sala-I-Martin (1993) analyze a similar model where both inputs are used in the production of both types of capital and their result are consistent with those presented in this chapter, as long as the degree of physical capital intensity is higher in the production of output than in the production of human capital.

56

Econ 620 2013

combining both results we reach the basic equation of our model with human capital,

k = sk u 1 ( + g A + g h + n ) k
which takes a very familiar form that we can solve for the steady state level of adjusted capital,

s k = 0 k * = u + g A + gh + n

1/1

y = k
*

( )
*

s =u + g A + gh + n

/1

Remember that our adjusted variables are just a convenient transformation but have little economic content so for practical purposes it is easier to think in terms of per capita variables so,

K Yi

* i

()

s t =A t h t k =A t h t + g A + gh + n

() ()

() ()

1/1

u
/1

()

s t =A t h t y =A t h t + g A + gh + n

() ()

() ()

and their steady state growth rates,

* = g + g g + B (1 u ) K i* ( t ) = A ( t ) h ( t ) k * K i A h A * = g + g g + B (1 u ) Yi * ( t ) = A ( t ) h ( t ) y * Y i A h A
In terms of income per capita (along a stable growth path) we can get a better grasp of the different factors at work.

s Yi ( t ) = + g + B (1 u ) + n A
*

/1

uA ( t ) h0e B (1 u )t

As in the Solow model, countries with higher saving rate or lower rate of population growth enjoy higher per capita income. The effects of education are somehow more complex. On one hand the time devoted to the acquisition of skills reduces the time available to produce commodities and therefore the level of per capita output, that is captured by g h = B (1 u ) in the denominator and the last u . But on the other hand, the time devoted to the acquisition of skills affects the growth rates of human capital, 57

Econ 620 2013 physical capital and output, e B (1 u )t . Since the growth effect is amplified every period, the positive effect of education on income per capita soon dominates its negative effect, leading to the positive association between income per capita and years of schooling that we observe in the data. Notice that even though the growth rate is constant, it does depend on an action of the agents populating our economy, namely, their choice of the fraction of time devoted to education, 1 u . This is one of the crucial differences with the Solow model where the choices of the representative agent did not affect the steady state growth rate of the economy.

2.3.3.3 Transitional Dynamics of the model

What does the human capital model imply for growth?53 Consider first the case of two countries with the same amount of human capital. Let us also assume that the two countries are identical in every respect apart from their initial level of physical capital. Since the growth rate of human capital is constant and identical in the two economies, we have the immediate conclusion that the level of human capital in the two economies will always be the same. Lets look at the steady-state ratio between physical and human capital,

K ( t ) k * A ( t ) h ( t ) L (t ) s = = k * A ( t ) = H ( t ) h (t ) L (t ) + g A + g h + n

1/1

uA ( t )

so since both economies have the same parameters and exogenous variables, they only differ on the initial levels of physical capital, both economies reach the same steady state level of adjusted capital and therefore both economies eventually have the same ratio of physical to human capital. As a result in the steady state both economies have identical amounts of human and physical capital (since they have the same ratio and the same amount of human capital), and therefore the same level of output. If one country happens to start with a lower level of physical capital, it will grow faster during the transition to the steady state and ultimately catch up the other country. In other words, for countries with the same level of human capital the model works just like the Solow model. The model implies convergence along the physical capital dimension. This feature is one of the main advantages of the human capital model: it preserves the successes of the Solow model in terms of explaining growth in rich countries. The situation is different if two countries start out with different initial levels of human capital. Assume, for example, that the first country has twice as much human capital as the second country (as before assume that the rest of the parameters and the initial level of physical capital are identical for both countries). Since human capital grows at the same constant rate in both countries, the ratio of human capital between the
53

Given the similarities between the structure of the dynamic equations in this model and in the Solow model with technological change, most of the conclusions we derived for that model are still valid in this environment, but we will find some additional implications. Besides we could draw a similar version of the graphical analysis conducted in chapter 3.

58

Econ 620 2013 countries will always be two to one. Since in each country, the ratio of physical to human capital is the same, the long-run ratio of physical capital between the two countries will be two to one as well. In other words, the country that starts out with less human capital never catches up to the rich country: convergence does not occur along the human capital dimension. We therefore see that the human capital model is, in principle, consistent with most of the evidence on the world income distribution. The model does predict convergence among rich countries (under the assumption that they have similar levels of human capital), but also relative stagnation of poor countries that start with little human capital. One of the implications of the Solow model is that given the observed differences in capital per capita across countries if nothing prevents the best technology to be adopted by all the countries we should observe large capital flows from rich to poor countries, but it seems that these patterns are not observed in the data. What are the implications of the human capital model for international capital flows? The best approach to answer this question is to calculate the implied return to capital in this model,

MPK =

Y 1 1 = K 1 ( uhLA ) = K i 1 ( uhA ) K

Since the marginal product of capital is increasing in the average level of education, h , this model is consistent with capital flowing to rich countries where the level of education is generally higher. The predictions for poor countries are not entirely pessimistic, however. Since the growth rate is endogenous, the model points to a potential path out of poverty: a country that invests a higher share of resources into education (or spends more time acquiring skills) can increase its long-run growth rate, and thereby converge to rich countries even if their initial level human capital is lower.

2.3.3.4 Empirical Evaluation of the aK Model a. Kaldors stylized facts.

1. A wide variety of growth rates (and of income levels). In these models differences in growth rates arise from differences in technology and/or saving. The rate of growth is endogenously determined by the rate of investment in physical capital (learning by doing), the amount of publicly provided infrastructures or the effort devoted to the accumulation of skills (human capital model). 2. Per capita output growth at a positive rate that shows no tendency to diminish. =K = sa n As we pointed out in the first section, Y i i K 1 3. The capital-output ratio shows no trend. Since Y = aK = , where a is Y a an endogenously determined constant.

59

Econ 620 2013 4. The return to capital shows no trend. The marginal product of capita, a, is constant.

b. Convergence.
We have defined convergence as the tendency for countries with lower initial income to grow faster and catch up with higher income countries. We know that the engine for convergence is based in diminishing returns to capital. In the presence of diminishing returns, at low levels of capital its marginal product is high and so it is output growth. The elimination of the diminishing returns to capital in the aK technology removes the engine for convergence, opening up a set of interesting possibilities where economies might temporarily converge, diverge or move along parallel paths. In general this model predicts at best, lack of divergence.

c. Limitations.
To achieve a balanced growth path, any aK model requires exactly constant returns to scale in the factors that could be reproduced. In general form we can write,

Y = aK
Using our basic differential equation in per capita terms,

= saK ( + n ) K = saK 1 n K K i i i i i

60

Econ 620 2013 If = 1 , we are fine, if < 1 , the model exhibits diminishing returns and eventually growth will cease, we are back in the Solow world. Finally, if > 1 then growth will take place at an increasing rate. Solow (1994) criticizes the very strong conditions, exactly constant returns to scale to reproducible factors, required by this class of models to generate stable growth.

d. Quantitative evaluation (human capital model).

d.1. Regression Analysis Mankiw, Romer and Weil (1992) used regression analysis to take a version of our human capital model to the data. Under the assumptions that economies are in steady state, the rate of technological change, g , is common across countries and that the initial level of technology, Ai ,0 , is orthogonal to the independent variables, i.e. it is uncorrelated with savings, education and population growth, they reached the following estimation equation,

ln yi* = 0 + 1 ln ( sk ,i ) + 2 ln ( sh ,i ) + 3 ln ( ni + g + ) + i

(1)

This specification requires a proxy for their measure of investment in education, sh ,i . They used the fraction of the working age population that is enrolled in school. The results of their exercise are summarized in the following table, Estimates of the Human capital model MRW 1985 Updated to 2000 .69 (.13) .96 (.13) .66 (.07) -1.73 (.41) .78 .70 (.13) -1.06 (.33) .60

ln ( sk ,i ) ln ( sh ,i )
ln ( ni + g + )

Adjusted R 2
Standard errors in brackets

These results are very impressive. Both measures of investment come out with the right sign and so does the effect of population growth. In particular the adjusted R 2 suggests that close to 80% of the income per capita differences across countries can be explained by differences in their physical capital, human capital and fertility. The immediate implication is that technology differences, ( Ai ) , have a somewhat limited role. If this conclusion was correct, it would imply that, as far as the causes of prosperity are concerned, we can limit our attention to differences in human and physical capital accumulation and abstract from technological differences across countries. It was soon noticed some of the limitations of Mankiw, Romer and Weils work. The assumption that the levels of technology are orthogonal is very difficult to justify.

61

Econ 620 2013 We not only expect Ai to vary across countries but also to be correlated with the rates of investment in physical capital, sk ,i , and human capital, sh ,i . It seems sensible to assume that countries that are more productive, high Ai , will also have higher rates of investment in physical and human capital and therefore the key right hand variables in (1) are positively correlated with the error term. As a result, OLS estimates and the adjusted R 2 will be biased upwards. This potential overestimation of the role of human and physical capital casts serious doubts over the previous analysis. Since the physical and human capital coefficients are incorrectly capturing most of the productivity differences. Given this problem, the literature has abandoned this approach and has moved closer to calibration procedures (an analysis similar than the one we conducted with the standard Solow model). The calibration results, as we will see in the next section, provide much weaker evidence in favor of the human capital model.

2.4. Beyond K, H and Ideas: Fundamental Causes of Growth

We began this course pointing out the incredible differences in income per capita across countries. Focusing on the five wealthiest countries and the five poorest ones, the following table reproduces their income levels and some of the variables we have identified as potential sources of those differences,
U.S.A. Luxembourg Canada Switzerland Australia Tanzania Uganda Burundi Malawi Niger Top 5 Bottom 5 Ratio Yi 35,439 34,941 33,337 30,965 29,858 1,124 1,123 1,055 1,048 1,011 32,908 1,072 30.7 Ki 87,330 107,283 82,443 107,870 88,076 1,171 988 1,118 1,185 1,153 94,600 1,123 84.2 h 11.8 9.5 10.7 9.8 10.6 4.8 4.6 4.7 5.0 3.8 10.48 4.59 2.3 s 0.20 0.27 0.25 0.30 0.25 0.10 0.02 0.07 0.07 0.08 0.25 0.07 3.7 n 0.010 0.008 0.012 0.007 0.014 0.024 0.027 0.021 0.030 0.033 0.01 0.03 0.4

All the data is from Hall and Jones (1999).

62

Econ 620 2013 On average the wealthiest countries have 30 times more income per worker than the poorest ones, their workers are equipped with almost 85 times more capital and they have been educated for almost 10.5 years as opposed to the 4.5 years of the workers in the poorest countries. Following Hall and Jones (1999) we are going to perform a growth accounting exercise in levels rather than in growth rates. As they argue levels capture the differences in long-run economic performance, are more relevant to well-being as measured by consumption, and with technology flowing relatively free across countries most models predict that all countries will converge to a common growth rate in the long run. As a consequence long-run differences in levels are the relevant differences to explain. Assume output is produced according to the following Cobb-Douglas production function,

Y = K ( AhL )

where K is the capital stock, A is a measure of total factor productivity, h is the average level of human capital and L is the size of the labor force. Output per capita is given by,

Yi = K i ( Ah )

Taking logs in both sides we reach the following expression that decomposes the (log) level of output per capita into the contributions of the (log) level of capital per capita, the (log) level in human capital per capita and the (log) level of total factor productivity
ln Yi = ln K i + (1 ) ln h + (1 ) ln A

(1)

Lets see how does (1) decompose output per capita. For that purpose think of the simplest framework one with constant saving, constant education per worker and constant technology, so that we have a steady state in per capita terms. Now consider the following thought experiment; the level of A rises without any change in saving or education per worker. An ideal decomposition would attribute all of the increase in output to the increase in A , since it is the only thing that has changed. Nonetheless, a decomposition like (1) attributes a fraction of the higher log of income per capita to increase in capital per capita and the remaining (1 ) portion of the increase in the log of output per capita to total factor productivity, while we know that all the increase comes from an increase in total factor productivity. What does actually happen? Well, with a constant saving rate, the higher output that results from the increase in A increases investment and the amount of physical capital. When the country reaches its new steady state, Ki and Yi will be higher by the same proportion.

63

Econ 620 2013 Since the capital-output ratio coincides in both steady states, the way proposed by Hall and Jones (1999) to address this issue is to subtract from both sides of (1) ln Yi , reaching
ln Y i ln Y i = ln K i + 1 ln h + 1 ln A ln Y i
i

(1 ) ln Y
ln Y i =

= ln K i

) ( ) ln Y ) + (1 ) ln h + (1 ) ln A
i

K ln i + ln h + ln A (1 ) Yi

The last equation decomposes output per worker into capital intensity, measured by the capital-output ratio, education and technology. Furthermore, using this equation in our previous thought experiment we get the answer we were looking for. Assuming = 1/ 3 and using the previous expression to decompose output per capita for the top-five and bottom-five economies we get54,

ln Yi
Top 5 countries Bottom 5 countries Difference in logs Relative contribution 10.4 6.98 3.42 100%

K ln i (1 ) Yi

ln h

ln A
9.03 6.59 2.44 71.35%

0.53 0.02 0.51 14.91%

0.84 0.37 0.47 13.74%

Only around 15% of the difference in GDP is explained by differences in capital intensity55, education accounts for another 15% of the difference, with the remaining
54

We have data on the average years of schooling per worker, now we need to map our data on years of schooling into its productive counterpart, h ( t ) . The labor literature suggests that additional years of schooling increase earnings proportionally. Labor economists explain earnings using what it is known as the Mincerian wage equation, ln wi = X i + Si where wi is wage earnings of the individual in some labor market, X i is a set of controls that might affect wages apart from education (family status, age, experience) and Si is years of schooling. The estimate of the coefficient is the rate of return to education, measuring the proportional increase in earnings resulting from one additional year of education. This literature provides estimates of that range between 0.06 and 0.1, i.e. it suggests that an increase in one year of education increases wages somewhere between 6% and 10%. Now if we assume that labor markets are competitive this implies that one more year of schooling increases worker productivity (ant wages) between 6 and 10 percent. We take the midpoint 8%, and we therefore estimate h ( t ) ignoring the other covariates as hi = exp ( 0.08 * Si ) . Notice that if markets are competitive, w = MPL = (1 ) y* Ah . Now assume we have two agents working on the same labor market that differ by one year of education; so that h H = h L exp(0.08 *1) . Then their wages are wH = (1 ) y* Ah L exp(0.08) and wL = (1 ) y* Ah L and their wage ratio is wH wL = exp(0.08) 1.08 . 55 As a curious way to illustrate these differences one can look at the variation in the productivity of chickens across countries. A chicken in the US lays around 1 egg per day while in a third world country it lays around 1 egg per week.

64

Econ 620 2013 70% of the difference left unexplained, what we have labeled as total factor productivity. Notice that after half a century of research we reach a result, in a crosscountry context, fully consistent with Solow (1957). He found that only one eighth of US output per capita growth between 1909 and 1949 was the results of physical capital accumulation. But the most important finding from Hall and Jones (1999) is that the contributions of physical capital, schooling and total factor productivity are not independent. Rich countries not only have more capital per worker, higher saving and lower fertility rates, a better educated labor force but they also combine them in a more efficient way. They find a correlation coefficient of .52 between the log of education and the log of total factor productivity and of .25 between the log of capital per worker and the log of total factor productivity. The next graph borrowed from the cited paper reproduces the strong positive correlation between output per worker and total factor productivity,

These strong correlations between the different engines of growth lead scholars to think that there is some underlying force that is driving the accumulation of inputs and the level of productivity. In words of Hall and Jones (1999) capital accumulation, education and technology are only proximate causes for growth, while the fundamental determinants of the wide variation in income levels across countries are still to be determined. Institutions (Acemoglu et al., 2001) Property Rights (De Soto, 1989) Incentives (Easterly, 2002) Geography (Bloom et al., 1998) Culture (Landes, 1998) Luck, history (Nunn, 2009), path dependency If one finds that inputs of production are able to account for most of the differences in income per capita, then growth economics could focus on explaining low 65

Output per worker (K i , H i , A )

Econ 620 2013 rates of factor accumulation, there would be ample scope for controversy over the policies better suited to engineer higher investment rates in various types of capital but some consensus could be reached in what are the intermediate goals of growth theory. But unfortunately most of the evidence suggests that differences in efficiency are at the root of the differences in output per capita, and therefore growth theory faces the additional task of explaining why with similar level of inputs some countries are able to produce much more output than others. Lets briefly discuss the main arguments supporting each of the hypotheses behind these fundamental determinants of income.

2.4.1. History, luck, path dependence and multiple equilibria

The basic flavor of multiple equilibria models is captured by the following game of investment. Assume the economy is populated by N investors indexed by i with the payoffs of the k -th individual and the rest of the economy summarized in the following table.

High investment i = k High investment i k Low investment i k

y ,y
H H

Low investment i = k
yL , yL yL , yL

yL , yL

If y H > y L > > 0 , we have two pure strategy symmetric equilibriums in this game. If the k -th individual expects all other agents to choose high investment, it is optimal for him to invest at the high rate. In the other hand, if the k -th individual expects all the others to choose low investment, low investment is his best response. Since the same analysis applies to any of the other individual agents, we end up with two symmetric equilibriums. These types of models highlight the importance of complementarities in many economic activities. For instance a relatively simple production process, manufacturing T-shirts, requires success along a surprisingly large number of different dimensions. Our T-shirt firm needs the basic inputs of production; cotton and polyester, machines, a competent and healthy workforce with the required know-how, a factory building, a continuous supply of energy and water Apart from these the production process must be kept secure from theft and expropriation, the firm must acquire licenses and obtain regulatory approval for production, a good transportation network that allows access to consumer market Finally, the managers of the firm need to know how to organize the production process, how to manage the work force These different activities are complementary (failure along any single dimension can have an important impact in output) and sometimes external to any individual firm (the market, as a coordination device, might play a very limited role).

66

Econ 620 2013

2.4.2. Geography
Nature, that is, the physical, ecological and geographical environment of nations can potentially play an important role in their economic performance. In words of Nobel Prize winner Gunnar Myrdal as serious study of the problems of underdevelopment should take into account the climate and its impact on soil, vegetation, animals, humans and physical assets. A more actual version of the geography hypothesis links poverty in many areas of the world to their disease environment, as pointed out by the World Health Organization in todays world, poor health has particularly pernicious effects on economic development in sub-Saharan Africa, South Asia, and pocket of high disease and intense poverty elsewhere and extending the coverage of crucial health services to the worlds poor could save millions of lives each year, reduce poverty and spur global development Along these lines it is well-documented in the microeconomics literature that unhealthy individuals are less productive, less able to learn and accumulate less physical capital56.

56

The adult survival rate is the fraction of 15 years old that will survive to age 60. Several authors have estimated the effects of height (a health outcome) on wages (a proxy for productivity). Their results account for the genetic variability in height and the potential correlation of health with other determinants of wages by instrumenting height with inputs into health in childhood that are not related to family income, such as distance to health facilities. Their results suggest that a 1 cm increase in height is associated with an 8% increase in wage in Colombia (Ribero and Nunez (2000)), a 9% in Ghana (Schultz (2002)), and a 7.8% in Brazil (Schultz (2002)).

67

Econ 620 2013 Weil (2006) proposes a growth accounting framework that incorporates health capital. Using micro-estimates to measure the contribution of this capital to productivity he concludes that around 20% of the variation in income per capita is explained by differences in health. Nonetheless it is important to notice that the fact that the burden of disease is heavier in poor nations today is as much a consequence as a cause of poverty.

2.4.3. Culture
Culture is viewed, by some social scientists, as a key determinant of the values, preferences and beliefs of individuals and societies. This values and beliefs potentially have an strong impact on economic performance. Weber (1930) argued that English piety, in particular, Protestantism, was an important driver of capitalist development. In his view, Protestantism led to a set of beliefs that emphasized hard work, thrift and saving. It also interpreted economic success as consistent with, even as signaling, being chosen by God. Many historians and scholars have argued that not only the rise of capitalism, but also the process of economic growth and industrialization are intimately linked to cultural and religious beliefs. Similar ideas are also proposed as explanations for why Latin American countries, with their Iberian heritage, are poor and unsuccessful, while their North American neighbors are more prosperous thanks to their Anglo-Saxon culture. A number of scholars have taken Webers hypothesis to the data, finding some support. The studies examine the persistent impacts of either the Protestant Reformation or historical overseas Protestant missionary activities on contemporary religious beliefs, education, or economic development finding evidence of long-term impact of Protestantism. Nonetheless, the direct impact of culture on development is still fairly unclear57.

2..4.4. Institutions
Douglas North that has widely explored the importance of institutions in the historical development process, offers the following definition,

57

Although no former Spanish or Portuguese colony has been successful economically as British colonies such as the United States, many former British colonies, such as those in Africa, India (up to a couple of decades ago), Bangladesh and the Caribbean, are poor today; Why did the Protestant ethic have such a large impact in North America and Australia and not in Africa or the Caribbean? Some authors claim that what matters is the European heritage. While North American population is mainly of European descent, the population of former British colonies in Africa is not of European descent. Again it is not difficult to come with counter-examples, the high rates of population with European descent of Uruguay and Argentina are associated with poor economic performance, while Singapore or Honk Kong have almost no European heritage and their economic record is outstanding. If some Asian cultural values are responsible for the successful growth experience of South Korea why do these same values not spur growth in North Korea? If Asian values are important for the current Chinese growth why did they not lead to a better economic performance during the first three decades that followed World War II?

68

Econ 620 2013 Institutions are the rules of the game in a society, more formally, are the humanly devised constraints that shape human interactions In consequence institutions structure incentives in human exchange, whether political, social, or economic This definition makes institutions a rather broad concept. We can think of the structure of property rights, the presence and functioning of markets (especially capital and insurance markets), the contractual framework available to individuals as some easily identifiable economic institutions. The proponents of this hypothesis expect societies with institutions that facilitate and encourage factor accumulation, innovation and the efficient allocation of resources to prosper relative to societies that do not have such institutions. Identifying the key institutional features that provide the right incentives58, exploring the interaction between different institutions, understanding the conflicts of interest at the source of institutional inertia are some of the most promising areas of research.

58

Most likely there is not a single mapping between institutions and economic outcomes. For instance, scholars often highlight the importance of private property arrangements as a requisite for development. But the introduction of private property in the former Soviet Union preceded the collapse of the Russian economy, while Chinas mixed-property system, where businesses are co-owned by private actors and local governments, has recently produced remarkable outcomes.

69

Econ 620 2013 Appendix I. Formally, we can combine Solows dynamic equation with the production function,
k k = sk ( n + g + ) k % k = sk 1 ( n + g + ) = k y = k y

to reach,

= sk 1 ( + n + g ) y
1

)
1

Since y = k k = y k 1 = y
1 y = sy ( + n + g )

using this result

Which we can rewrite in terms of ln y,

1 ln y ln y = se ( + n + g ) t

and that we are going to linearize around ln y*

1 ln y* 1 1 ln y* ln y * se ( + n + g ) + s ln y ln y e t

ln y* ln y ( 1) se ln y ln y * t ln y ( 1) ( + n + g ) ln y ln y* t

For convenience lets define ( 1) ( + n + g ) < 0

ln y solve _ diff _ equation rearrange ln y ln y* ln yt = ln y* + ln y0 ln y * e t t

substract _ ln( y0 ) ln yt = ln y* 1 e t + ln y0e t ln yt ln y0 = ln y * 1 e t ln y0 1 e t

Given that 1 et is positive (since < 0 ), this equation implies that the growth rate between 0 and t ( ln y ( t ) ln y ( 0 ) ) is positively correlated with the steady state 70

Econ 620 2013 level of income and negatively correlated with the initial level of income. What is even more important we can empirically measure it, having information on growth rates, initial and steady state levels of income59. Given that 1 et is positive (since < 0 ), this equation implies that the growth rate between 0 and t ( ln y ( t ) ln y ( 0 ) ) is positively correlated with the steady state level of income and negatively correlated with the initial level of income. What is even more important we can empirically measure it, having information on growth rates, initial and steady state levels of income60.
59

Before proceeding with the estimation one additional step is needed, since we dont have data in units of

yt = Yit At , then our effective labor, we need to rewrite it in terms of per capita variables. Since Yit = At yt equation becomes.
Y ln it At Yi 0 t * t = ln y 1 e + ln e A0

Since y* =

* Yit Y* Y* = i1 = i 2 At A1 A2

is constant, for convenience we evaluate it at the initial period.

Y * i 0 1 e t + ln Yi 0 e t = ln Y * 1 e t + ln Y e t ln A = ln i 0 0 i 0 A A0 0 A * t * t ln Yit = ln Yi 0 e t ln t = ln Yi 0 e t + gt Yi 0 1 e + ln Yi 0 1 e + ln A0 Y ln it At

ln Y * 1 e t + ln Yit ln Yi 0 = ln Yi 0 e t ln Yi 0 + gt i 0 Y * t t ln it = gt + ln Yi 0 1 e Yi 0 1 e ln Yi 0 Y ln it = a + ln Yi 0 j + j Yi 0 j

60

Before proceeding with the estimation one additional step is needed, since we dont have data in units of

yt = Yit At , then our effective labor, we need to rewrite it in terms of per capita variables. Since Yit = At yt equation becomes.
Y ln it At Yi 0 t * t = ln y 1 e + ln e A0

Since y* =

* Yit Y* Y* = i1 = i 2 At A1 A2

is constant, for convenience we evaluate it at the initial period.

Y * i 0 1 e t + ln Yi 0 e t = ln Y * 1 e t + ln Y e t ln A = ln i 0 0 i 0 A A0 0 A * t * t ln Yit = ln Yi 0 e t ln t = ln Yi 0 e t + gt Yi 0 1 e + ln Yi 0 1 e + ln A0 Y ln it At

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Econ 620 2013

ln Y * 1 e t + ln Yit ln Yi 0 = ln Yi 0 e t ln Yi 0 + gt i 0 Y * t ln it = gt + ln Yi 0 1 e t Yi 0 1 e ln Yi 0 Y ln it = a + ln Yi 0 j + j Yi 0 j

72