Lecture 14 Macroeconomic Theory

ECON102
Summer 2003

Solow Growth Model II:

Technological Progress
Data shows that both y and k grow Exogenous technological change: Y = F(K,L,A) where A is Technology parameter which grows exogenously Consider 3 possible ways technology can enter: - Y=AF(K,L) (Hicks Neutral) - Y=F(AK,L) (Solow Neutral) - Y=F(K,AL) (Harrod Neutral)

Define: AL = efficiency units of labour Here A can be thought of as education, training etc, human capital For the Cobb-Douglas production function, all three forms are equivalent, but in general, this may not be the case Solow model deals with labour-augmenting or Harrod Neutral form of technological progress Define:

Harrod Neutral Technology:

Y = F (K , AL) using CRS of Y, divide by AL: Y = F ( K ,1) AL AL y= Y ; k = K AL AL y = f (k ) as before, but with new definitions of y and k

Steady State Growth:

At the steady state: y = k = 0 y k Let A grow at a constant rate g For k = K/AL, the growth rate of K must equal the sum of the growth rates of A and L Rate of growth of : K: K = sF (K , AL) K K K

Rate of growth of A and L: A = g; L = n A L k = 0 when : sF (K , AL) K = n + g K or sF (K , AL) K = (n + g )K

Dividing through by AL: sf (k ) = (n + g + )k

Behaviour Of Key Variables:

Levels: Variable K L A Y K/L Y/L k y Growth Rate n+g n g n+g g g 0 0

Behaviour Of Real Wage And Real Interest Rate

Recall: r = Y K w = Y L Since Y = F (K , AL) = ALf (k ) Y = f '(k ); Y = Af (k ) Akf '(k ) K L r = f(k) ; w = A[f(k) kf(k)]

Per Capita: Efficiency Units:

What we have managed to explain:

We have now explained the four stylised facts presented earlier: 1. 2. 3. 4. Y/K is constant K/L grows at a constant rate g r is constant w grows at a constant rate g

Golden Rule of Capital Accumulation

Solow Model gives the following steady state condition: sf(k) = ( + n + g)k where s,,n,g are exogenous constants. Equation (1) is one equation in one unknown k. Question: Is the capital obtained from (1) the one which maximises social welfare? (1)

Problem: Rate of growth, g, is exogenous

Social Welfare: Adopt a simple rule consumption per capita in the steady state. Trade off: More consumption now lowers savings and thus lowers investment. This implies that there is less capital and less consumption in the future. Golden Rule gives the level of capital that maximises consumption on the steady state balanced growth path. Define consumption as: c = f(k) sf(k) output savings (2)

In the steady state: k = 0 sf(k) = (n + g + )k Substitute (3) into (2): c* = f(k*) (n + g + )k* The k that maximises c* satisfies: f(kGR) = n + g + MPK = n + g + (4) (3)

i.e.

 In a competitive economy, the firm maximises profits: F(K,AL) K rK wL

Investment, Depreciation , Output

The Golden Rule

It chooses K to satisfy: MPK = + r Golden Rule for a competitive economy is: r=n+g Real Rate of = Real Rate of Interest Growth

}
kGR

cGR

}
k*

f(k)

(n+g+) k c* sf(k) sGRf(k)

Sources of Growth Growth Accounting

From the Production Function, Y = F(K,L,A), output can grow for one of three reasons: 1. 2. 3. Growth in K Growth in L Growth in A (Technology). Decomposing Growth in Y amongst these three sources of growth is known as growth accounting. Part of growth due to A is called Total Factor Productivity.

Illustration: Cobb Douglas Production Function Y = AF(K,L) = AKL1- 0<<1

Y=AKL1-+ KAK1L1-+(1-)LA KL- Dividing both sides by Y: Y = A + K + (1 ) L Y A K L We have data on : Y , , K , L Y K L we can calculate A from above. A

By definition, it is the "unaccounted" or "residual" part of growth : A = Y K + (1 ) L A Y K L For this reason, it is also known as the Solow Residual. In the UK, about half of growth is attributed to TFP growth. In the US, there is a more even split between the three sources.