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Total GDP (2008): $70T Population (2009 est): 6.8B GDP per Capita: $10,000 Population Growth: 1.17% GDP Growth (2008 est.): 3.8%
GDP per capita is probably the best measure of a countrys well being
Note. However, that growth rates vary significantly across countries/regions. Do you see a pattern here?
Region
GDP
% of World GDP
20% 21% 6% 11% 5% .09%
At the current trends, the standard of living in China will surpass that of the US in 25 years!
As a general rule, low income (developing) countries tend to have higher average rates of growth than do high income countries
The implication here is that eventually, poorer countries should eventually catch up to wealthier countries in terms of per capita income a concept known as convergence
Haiti GDP: $11.5B (#146) GDP Per Capita: $1,200 (#207) GDP Growth: -5.1% (#213)
Qatar GDP: $150B (#59) GDP Per Capita: $179,000 (#1) GDP Growth: 16.3% (#1)
At current rates, Per capita income in Qatar will quadruple to $716,000 over the next decade. Over the same time period, per capita GDP in Haiti will drop by roughly 40%to $710!!!
So, what is Haiti doing wrong? (Or, what is Qatar doing right?)
To understand this, lets look at the sources of economic growth.where does production come from? is a function of
Real GDP
Y ! F A, K , L
Productivity Capital Stock Labor
Real GDP = Constant Dollar (Inflation adjusted) value of all goods and services produced in the United States Capital Stock = Constant dollar value of private, non-residential fixed assets Labor = Private Sector Employment Productivity = Production unaccounted for by capital or labor
A convenient functional form for growth accounting is the Cobb-Douglas production function. It takes the form:
Y ! AK L
where
E F !1
With the Cobb-Douglas production function, the parameters have clear interpretations:
E
Capitals share of income (what % of total income in the US accrues to owners of capital) Elasticity of output with respect to capital (% increase in output resulting from a 1% increase in capital)
F
Labors share of income (what % of total income in the US accrues to owners of labor) Elasticity of output with respect to labor (% increase in output resulting from a 1% increase in labor)
Y ! AK L
1 3
2 3
We can rewrite the production function in terms of growth rates to decompose GDP growth into growth of factors:
Year
Employment (thousands)
% (Y ! ? ,467
ln ,257
*100 ! 1.85 ln 11 11 A % (K ! ? ,883
ln ,632
*100 ! 1.97 ln 12 12 A % (L ! ? ln 137,180
ln ,155
A*100 ! 1.48 135
Note that capital is growing faster than employment
%(A ! 1.85
Year
Employment (thousands)
% (Y ! % (K ! % (L !
12 1 ?ln ,883
ln ,440
A*100 ! 3.22 68 137 ?ln ,180
ln 29,923
A*100 ! 2.23 68
1 3.22
2 2.23
! .84 3 3
%(A ! 3.39
Contributions to growth from capital, labor, and technology vary across time period
1939 - 1948
1948 - 1973
1973-1993
1993-2007
Real GDP growth is declining over time. Capital has been growing faster than labor
Our simple model of economic growth begins with a production function with one key property
Change in Production
Y ! F A, K , L
Y
MPK ! (Y (K
MPK ! 10
MPK ! .5
F ( A, K , L )
.5
As the capital stock increases (given a fixed level of employment), the productivity of capital declines!!
We are concerned with capital based growth. Therefore, growth in productivity and employment will be takes as given
Y ! AK L
Productivity grows at rate
1 3
2 3
Population grows at rate
gL L LF L! Pop Pop LF
gA
= Employment Ratio
= Participation rate
( Assumed Constant)
( Assumed Constant)
Y ! AK L
1 3 2 3
Divide both sides by labor to represent our variables in per capita terms
Y AK L K y! ! ! A ! Ak 1 2 L L 3 3 L L
Per capita output Productivity
1 3
1 3
In general, lets assume lower case letters refer to per capita variables
Recall that capital exhibits diminishing marginal productivity that is as capital relative to labor rises, its contribution to production shrinks
y ! Ak
1 3
Lets use an example. The current level of capital per capita will determine the current standard of living
y ! Ak
1 3
y ! 6 ! 12 8
1 3
k
k !8
Next, assume that households save a constant fraction of their disposable income
Income Less Taxes
S ! U Y T
Savings Constant between zero and one
Again, convert everything to per capital terms by dividing through by the labor force
S Y T !U L L L
s ! U y t
U ! 10% t !0
y, s
y ! Ak
1 3
y ! 6 ! 12 8
1 3
s ! U y t
s ! .10 0 ! 1.2 12
k !8
KEY POINT: Savings = Household income that hasnt been spent Investment = Corporate purchases of capital goods (plant, equipment, etc) The role of the financial sector is to make funds saved by households available for firms to borrow for investment activities
Households save their income by opening savings accounts, buying stocks and bonds, etc
Firms access these funds by taking out loans, issuing stocks and bonds, etc. and use the funds for investment activities
s ! U y t
The financial sector handles these deposits
I !i L
Investment per capita
Households save their income by opening savings accounts, buying stocks and bonds, etc
Firms access these funds by taking out loans, issuing stocks and bonds, etc. and use the funds for investment activities
s ! U y t
The financial sector handles these deposits
I !i L
Investment per capita
s!i
Investment represents the purchase of new capital equipment. This will affect the capital stock in the future
Annual Depreciation Rate Investment Expenditures
K ' ! (1 H ) K I
Future capital stock
In our example
H ! 10% g L ! 2% L ! 1,000 K ! 8,000 I ! S ! 1,200
L' ! .02 ,000 ! 1,020 1 1 K ' 8,400 k'! ! ! 8.24 L' 1,020
Calculated
K' K I ! (1 H ) L L L
Multiply and divide the left hand side by future labor supply
k g L
! (1 H )k i 1
'
k' !
(1 H )k i 1 gL
(1 H )k i k'! 1 gl
Future capital stock per capita
In our example
H ! 10% g L ! 2% L ! 1,000 K ! 8,000 I ! S ! 1,200
Given
Calculated
Just as a reference, lets figure out how much investment per capita would be required to maintain a constant level of capital per capita
~ 1 k ' g L ! (1 H ) k i k' ! k
~ i ! H g L
k
In our example
H ! 10% g L ! 2% L ! 1,000 K ! 8,000 I ! S ! 1,200
Given
Calculated
In our example
H ! 10% g L ! 2% L ! 1,000 K ! 8,000
(1 H )k i k'! 1 gl
~ y , i, i
y ! Ak
1 3
i ! s ! U y t
1
y ! 6 3 ! 12 8
i ! s ! 1.2
~ i ! .96
k'!
k !8
Now we have all the components to calculate next years output per capita and the rate of growth
1 3
1 3
~ y , i, i
y ! Ak
1 3
y ! 12.11
i ! s ! U y t
y ! 12
i ! s ! 1.2
~ i ! .96
k !8
k ' ! 8.24
k ' ! 8.24
y ! 6 .24 ! 12.11 8
Evolution of Capital
New Output
y ! 6 .46 ! 12.22 8
1 3
The rate of growth depends on the level of investment relative to the break even level of investment.
Actual investment based on current savings
~ i ! g L H
k
1 3
~ y , i, i
y ! Ak
i ! s ! U y t
i!s
~ i
Level of investment needed to maintain current capital stock
Eventually, actual investment will equal break even investment and growth ceases (in per capita terms). This is what we call the steady state.
~ i ! g L H
k
~ y , i, i
yss
y ! Ak
1 3
i ! s ! U y t
~ i!s!i
k ss
y ! Ak
1 3
s ! U y t
i ! H g L k
s!i
With a little algebra, we can solve for the steady state in our example.
gA ! 0 g L ! 2% A!6 t!0 U ! 10% H ! 10%
i ! H g L k
U y t ! H g L k
1 U Ak 3 t ! H g L
k
1 3
Substitute condition 1
UAk ! H g L
k UA k ! H g L
3 2
Solve for k
c ! U
y t
! .9 .40 0
! 12.06 1 13
(1 H ) k i .10
.18 1.34 1 11 k'! ! ! 11.18 1 gL 1 .02
Eventually, actual investment will equal break even investment and growth ceases (in per capita terms). This is what we call the steady state.
~ i ! g L H
k
~ y , i, i
yss ! 13.40
y ! Ak
1 3
i ! s ! U y t
i ! s ! 1.34
In the steady state (with no productivity growth), all per capita variables have zero growth!
k ss ! 11.18
Suppose we started out example economy above its eventual steady state
gA ! 0 g L ! 2% A!6 K ! 15,000 L ! 1,000 t!0 U ! 10% H ! 10%
y ! Ak ! 6
! 14.8 15
k ! 15
1 3
1 3
i ! s ! U y t
! .10 .8 0
! 1.48 14
(1 H )k i .10
1.48 1 15 k'! ! ! 14.7 1 gL 1 .02
1 3
1 3
An economy above its steady state shrinks (in per capita terms) towards its steady state.
~ y , i, i
~ i ! g L H
k
1 3
y ! Ak
y ! 14.8
~ i ! 1.8 i ! 1.48
i ! s ! U y t
An economy above its steady state cant generate enough savings to support its capital stock!
k ! 15
Absolute convergence refers to the premise that every country will converge towards a common steady state
Investment needed to maintain current capital/labor ratio Actual investment (equals savings)
Steady State
k
Countries above their eventual steady state will shrink towards it
1 2
Developing countries have very little capital, but A LOT of labor. Hence, the price of labor is low, the return to capital is very high High returns to capital attract a lot of investment. As the capital stock grows relative to the labor force, output, consumption, and real wages grow while interest rates (returns to capital fall) Eventually, a country matures (i.e. reaches its steady state level of capital). At this point, growth can no longer be achieved by investment in capital. Growth must be knowledge based improving productivity!
y ! Ak
Productivity
1 3
1%
1.5%
Developing countries are well below their steady state and, hence should grow faster than developed countries who are at or near their steady states a concept known as absolute convergence Examples of Absolute Convergence (Developing Countries) China (GDP per capita = $6,300, GDP Growth = 9.3%) Armenia (GDP per capita = $5,300, GDP Growth = 13.9%) Chad (GDP per capita = $1,800, GDP Growth = 18.0%) Angola (GDP per capita = $3,200, GDP Growth = 19.1%) Examples of Absolute Convergence (Mature Countries) Canada (GDP per capita = $32,900, GDP Growth = 2.9%) United Kingdom (GDP per capita = $30,900, GDP Growth = 1.7%) Japan (GDP per capita = $30,700, GDP Growth = 2.4%) Australia (GDP per capita = $32,000, GDP Growth = 2.6%)
Developing Countries with Low Growth Madagascar(GDP per capita = $900, GDP Growth = - 2.0%) Iraq (GDP per capita = $3,400, GDP Growth = - 3.0%) North Korea (GDP per capita = $1,800, GDP Growth = 1.0%) Haiti (GDP per capita = $1,200, GDP Growth = -5.1%)
Developed Countries with high Growth Hong Kong (GDP per capita = $37,400, GDP Growth = 6.9%) Iceland (GDP per capita = $34,900, GDP Growth = 6.5%) Singapore (GDP per capita = $29,900, GDP Growth = 5.7%) Qatar (GDP Per Capita = $179,000, GDP Growth = 16.3%)
y ! Ak ! 64 ! 9.52
1 3
1 3
1 3
1 3
y ! 12 g y ! .91%
Even though Country B is poorer, it is growing slower than country A (in per capita terms)!
With a higher rate of population growth, country B has a much lower steady state than country A!!!
~ y , i, i
~ iB ! 15 .10 . k ~ iA ! 02 .10 . k
i ! U y t
k B ss
UA ! H g L
3 2
3 2
k !4
B
k !8
A
k A ss ! 11.18
Conditional convergence suggests that every country converges to its own unique steady state. Countries that are close to their unique steady state will grow slowly while those far away will grow rapidly. Haiti
Population Growth: 2.3% GDP/Capita: $1,600 GDP Growth: -1.5% High Population Growth (Haiti) Low Population Growth (Argentina)
Argentina
Population Growth: .96% GDP/Capita: $13,700 GDP Growth: 8.7% Steady State (Haiti) Steady State (Argentina)
Haiti is currently ABOVE its steady state (GDP per capita is falling due to a high population growth rate
Argentina, with its low population growth is well below its steady state growing rapidly towards it
Conditional convergence suggests that every country converges to its own unique steady state. Countries that are close to their unique steady state will grow slowly while those far away will grow rapidly. Zimbabwe
GDP/Capita: $2,100 GDP Growth: -7% Investment Rate (%0f GDP): 7%
y
High Savings Rate (Hong Kong)
Hong Kong
GDP/Capita: $37,400 GDP Growth: 6.9% Investment Rate (% of GDP): 21.2% Steady State (Zimbabwe) Steady State (Hong Kong) Low Savings Rate (Zimbabwe)
Zimbabwe is currently ABOVE its steady state (GDP per capita is falling due to low investment rate
Hong Kong, with its high investment rate is well below its steady state growing rapidly towards it
Conditional convergence suggests that every country converges to its own unique steady state. Countries that are close to their unique steady state will grow slowly while those far away will grow rapidly. France
GDP/Capita: $30,000 GDP Growth: 1.6% Government (%0f GDP): 55%
y
Small Government (US) Large Government (France)
USA
GDP/Capita: $42,000 GDP Growth: 3.5% Government (% of GDP): 18%
France has a lower steady state due to its larger public sector. Even though its per capita income is lower than the US, its growth is slower
The smaller government of the US increases the steady state and, hence, economic growth
Consider policies to lower your population growth. Try to increase your pool of savings (open up to international capital
markets)
y ! Ak
Our model begins with a relationship between the capital stock and production
y ! ci
These goods and services that we produce can either be consumed or used for investment purposes (note: taxes are zero)
y ! c g L k H
In the steady state, investment simply maintains the existing steady state
c ! y g L ! Ak g L k H k H
1 3
Maybe we should be choosing a steady state with the highest level of consumption!
Steady state consumption is a function of steady state capital. If we want to maximize steady state consumption, we need to look at how consumption changes when the capital stock changes
1 3
c ! Ak g L H k
dc 1 ! Ak 3 g L H dk 3
Change in capital maintenance costs per unit change in steady state capital
dc 1 ! Ak 3 g L ! 0 H dk 3
~ i ! g L H
k
1 3
~ y, i
y ! Ak
k*
In this region, an increase in capital increases production by more than the increase in maintenance costs consumption increases In this region, an increase in capital increases production by less than the increase in maintenance costs consumption decreases
1 Ak 3 g L ! 0 H 3
A k* ! 3H g L
gA ! 0 g L ! 2% A!6 t!0 U ! 10% H ! 10%
3 2
We can solve for the steady state capital that maximizes consumption
6 k* ! 3.10 .02 ! 68
3 2
~ y , i, i
~ i ! g L H k
y ! Ak
1 3
i ! s ! .10y t
k * ! 11
Steady state with a 10% investment rate
k * ! 68
Steady state capital that maximizes consumption
k max ! 353
6 k* ! 3.10 .02
! 68
y ! 668
! 24.5
i ! 02 .10
! 8.16 . 68 c ! 24.5 8.16 ! 16.34
1 3
3 2
In this example, we could increase consumption by 30% by altering the savings rate!!
By comparing steady states, we can find the savings rate associated with maximum consumption
gA ! 0 g L ! 2% A!6 t!0 U ! 10% H ! 10%
Steady State with a given Savings Rate Optimal Steady State
UA k ! H g L
3 2
1 A k* ! 3 H g L
3 2
U* !
1 3
y ! Ak
1 3
$14,264B
$10,057B
$1,994B
$2,882B
The savings rate in the US is currently around 4%, but what we really want is the investment rate
$14,264B
$10,057B
In the steady state
$1,994B
$2,882B
UA k ! H g L
3 2
1 3 2 UA ! A 2 U y ! Ak ! A H g H g L L 1 3 3 2
1 3
3 2
1 2
A ! 1,194
Now, suppose that we could increase the investment rate to 33% as our model prescribes
Production (2008) Consumption (2008) Investment (2008) Government Purchases (2008)
$14,264B
$10,057B
In the steady state
$1,994B
$2,882B
1 2
~ y , i, i
i ! .33 y
i ! .14 y
Projected Steady State (y=$68,000)
k'
c
Immediate drop in consumption as economy responds to policy change
time
Growth of per capita consumption under old policy regime = 1.5% Growth of per capita consumption increases during transition period Growth of per capita consumption returns to 1.5%