Augmenting the Solow model and Growth Policy

Macroeconomic Theory I

ECON222

Fall 2017

Macroeconomic Theory I (ECON222) Long-Run Economic Growth Fall 2017 1 / 10

Augmenting the Solow Model

The basic Solow model can be augmented in various ways

Allowing for "human capital"

Allowing for ongoing productivity growth

,! via human capital accumulation or R&D
,! endogenous growth models

Adding in the eects of government infrastructure

Incorporating environmental impacts

,! Dynamic Integrated Climate-Economy (DICE) models

Macroeconomic Theory I (ECON222) Long-Run Economic Growth Fall 2017 2 / 10

Example: Adding human capital
Change aggregate production function to

Yt = AF (Kt , hNt )

where h = human capital per worker

In per worker terms this is

yt = Af (kt , h)

,! still diminishing returns to k, for given value of h

Cobb-Douglas example:

yt = Ah1
kt

,! eectively replaces A with Ah1

Macroeconomic Theory I (ECON222) Long-Run Economic Growth Fall 2017 3 / 10

Implications

Changes in h act like other changes in productivity growth

Emphasizes the important role of skill acquisition (e.g. education)

Fits the facts on cross-country dierences and conditional

convergence better
,! can measure investment in human capital across countries

Macroeconomic Theory I (ECON222) Long-Run Economic Growth Fall 2017 4 / 10

Example: endogenous growth with human capital

Suppose human capital per worker is proportional to physical capital

per worker
ht = Bkt
,! may reect a spillover or government investment

Then the Cobb-Douglas production function implies

yt = Akt (Bkt )1

yt = AB 1 kt

,! linear in k

Macroeconomic Theory I (ECON222) Long-Run Economic Growth Fall 2017 5 / 10

Endogenous growth (continued)
Now we have the dynamic equation

k = sAB 1
k (n + d )k

Dividing by k yields
k
= sAB 1
(n + d )
k
,! if sAB 1 > n + d ) k grows over time at a constant rate

The long-run growth rate is "endogenously" determined:

y
= sAB 1
(n + d )
y
,! per capita output never reaches a steady state

Macroeconomic Theory I (ECON222) Long-Run Economic Growth Fall 2017 6 / 10

Government Policies and Long-Run Living Standards

Government policies that are useful in raising a countrys long-run

standard of living include:
,! polices to raise the saving rate, s
,! policies to raise investment in human capital, h
,! policies to raise the rate of productivity, A

Macroeconomic Theory I (ECON222) Long-Run Economic Growth Fall 2017 7 / 10

Policies to Aect the Saving Rate

By taxing consumption (e.g. HST) a government eectively

encourages saving

A government can increase the amount that it saves (i.e. reduce its
decit)

Forced savings such as the Canada Pension Plan (CPP).

Macroeconomic Theory I (ECON222) Long-Run Economic Growth Fall 2017 8 / 10

Building Human Capital

Research nds a strong connection between growth and human capital

,! issues of measurement e.g. years of schooling vs. quality of
schooling

Governments aect human capital through education policies,

training programs, health programs, etc.

Productivity growth may increase if barriers to entrepreneurial

activity are removed.

Macroeconomic Theory I (ECON222) Long-Run Economic Growth Fall 2017 9 / 10

 Author's personal copy

246 Economics of Education External Benefits of Schooling

4
Conditional growth

4
4 2 0 2 4 6
Conditional years of education

Figure 1 Association between years of schooling and long-run economic growth. Added-variable plot of a regression of the
average annual rate of growth (in percent) of real GDP per capita in 19602000 on average years of schooling in 1960 and the initial
level of real GDP per capita in 1960.

in particular the institutional framework of the economy.
Both issues are discussed further below.
However, most importantly, using average years of
schooling as an education measure implicitly assumes
that a year of schooling delivers the same increase in
knowledge and skills regardless of the education system.
This measure also assumes that formal schooling is the
primary source of education and that variations in the
quality of nonschool factors affecting learning have a
negligible effect on education outcomes. This neglect of
cross-country differences in the quality of education is the
major drawback of such a quantitative measure.
Initial Evidence on the Quality of
Education and Economic Growth
Quite clearly, the average student in Ghana or Peru does
not gain the same amount of knowledge in any year of
schooling as the average student in Finland or Korea;
however, using measures of years of schooling assumes
that they are equivalent. In addition, using years of school-
ing implicitly assumes that all skills and human capital
come from formal schooling. Yet, extensive evidence on
knowledge development and cognitive skills indicates that
a variety of factors outside of school family, peers, and
others have a direct and powerful influence. Ignoring
these nonschool factors introduces another element of
measurement error into the growth analyses.
Since the mid-1960s, international agencies, such as
the International Association for the Evaluation of Edu-
cational Achievement (IEA) and the Organization for
Economic Co-operation and Development (OECD),
have conducted many international tests such as the
Trends in International Mathematics and Science Study
(TIMSS), the Programme for International Student As-
sessment (PISA), and their predecessors of student
performance in cognitive skills mathematics, involving
science, and other subjects. In order to make performance
on a total of 36 international tests from 12 testing occa-
sions comparable, Hanushek and Woessmann (2009)
develop a common metric to adjust both the level of test
performance and its variation through two data transfor-
mations. First, each of the separate international tests is
benchmarked to a comparable level by calibrating the US
international performance over time to the external stan-
dard of the available US longitudinal test (the National
Assessment of Educational Progress, NAEP). Second, the
dispersion of the tests is standardized by holding the score
variance constant within a group of 13 OECD countries
with relatively stable secondary school attendance rates
over time.
Figure 2 reports average performance at the standar-
dized tests, which serves as a proxy for the quality of
education. The variation in the quality of education that
exists among OECD countries is already substantial, but
the difference from developing countries in the average
amount of learning acquired after a given amount of

International Encyclopedia of Education (2010), vol. 2, pp. 245-252

 Author's personal copy

Education and Economic Growth 249

Conditional growth

4
1.5 1 0.5 0 0.5 1
Conditional test score
Figure 3 Test scores and long-run economic growth. Added-variable plots of a regression of the average annual rate of growth
(in percent) of real GDP per capita in 19602000 on the initial level of real GDP per capita in 1960, average test scores on international
student achievement tests, and average years of schooling in 1960. Calculations from Hanushek, E. A. and Woessmann, L. (2008).

1
Conditional growth

2
4 2 0 2 4
Conditional years of education
Figure 4 Years of schooling and economic growth after controlling for test scores. Added-variable plots of a regression of the average
annual rate of growth (in percent) of real GDP per capita in 19602000 on the initial level of real GDP per capita in 1960, average test
scores on international student achievement tests, and average years of schooling in 1960. Calculations from Hanushek, E. A. and
Woessmann, L. (2008).

cognitive skills remains qualitatively the same when mea-
sured just by the tests performed at the level of lower
secondary education, which seems the most readily com-
parable level. The results are also robust to performing the
analyses in two subperiods, 19601980 and 19802000, and
to dropping East Asian countries (which have both high
levels of cognitive skill and rapidly growing economies).
All in all, the results do not appear to be an artifact of the
specific time period, set of countries, or achievement mea-
surement decisions.
Results are also confirmed when looking at whether a
countrys estimated cognitive skills affect the earnings of
immigrants working in the United States. Higher home-
country cognitive skills translate into higher earnings

International Encyclopedia of Education (2010), vol. 2, pp. 245-252

Increasing productivity

Improving Infrastructure

Encouraging Research and Development

Industrial policy

Market Policy

Tax policy

Macroeconomic Theory I (ECON222) Long-Run Economic Growth Fall 2017 10 / 10