Download Long-Run Economic Growth, Part 2 Agenda The Solow Model The

Agenda
• Fundamental Determinants of Living Standards.
Long-Run Economic Growth,
Part 2
• Policies to Raise Long-Run Living Standards.
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The Solow Model
The Solow Model
• Fundamental determinants of living standards:
• Fundamental determinants of living standards:
¾ Increasing the saving rate:
¾ The saving rate.
¾ Population growth.
¾ Productivity growth.
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Effect of an increase in the saving rate
The Solow Model
Y/N
• The adjustment mechanism:
Y/N = A*f(K/N)
(Y/N)A
¾ A higher saving rate shifts the saving function up.
Ib/N = (n + d)K/N
(S/N)A = (Ib/N)A
¾ At the original K/N, at (K/N)A, S/N is now greater
than Ib/N.
S/N = s*A*f(K/N)
A
¾ Consequently, K/N will increase, causing:
(K/N)A
• Y/N to increase along the production function,
• S/N to increase along the new saving function, and
• Ib/N to increase along the balanced investment function.
K/N
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The Solow Model
The Solow Model
• The adjustment mechanism (continued):
• The adjustment mechanism (continued):
¾ At B, Y/N has increased, K/N has increased, S/N
has increased, and Ib/N has increased.
¾ Because of diminishing marginal product of
capital, the increase in S/N is smaller than the
increase in Ib/N for every increase in K/N.
¾ At steady state B, ΔY/Y = ΔN/N = ΔK/K.
¾ Eventually S/N will equal Ib/N at a new, higher
steady state at B.
¾ During the transition period from steady state A to
steady state B:
• ΔY/Y > ΔN/N because Y/N was increasing, and
• ΔK/K > ΔN/N because K/N was increasing.
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The Solow Model
The Solow Model
• Fundamental determinants of living standards:
• Fundamental determinants of living standards:
¾ Increasing the saving rate means:
¾ Increasing the saving rate:
• A higher capital-labor ratio, K/N,
• Should raising the saving rate be a policy goal?
• A higher output per worker, Y/N, and
– Not necessarily.
» There is a trade-off between present and future consumption.
» The cost is lower consumption in the short run.
• A higher consumption per worker, C/N.
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Effect of a faster population growth rate
The Solow Model
Y/N
• Fundamental determinants of living standards:
Y/N = A*f(K/N)
(Y/N)A
¾ Slowing the population growth rate:
Ib/N = (n + d)K/N
(S/N)A = (Ib/N)A
S/N = s*A*f(K/N)
A
(K/N)A
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K/N
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The Solow Model
The Solow Model
• The adjustment mechanism:
• The adjustment mechanism (continued):
¾ A slower population growth rate rotates the
balanced investment function down.
¾ Because of diminishing marginal product of
capital, the increase in S/N is smaller than the
increase in Ib/N for every increase in K/N.
¾ At the original K/N, at (K/N)A, S/N is now greater
than Ib/N.
¾ Eventually S/N will equal Ib/N at a new, higher
steady state at B.
¾ Consequently, K/N will increase, causing:
• Y/N to increase along the production function,
• S/N to increase along the saving function, and
• Ib/N to increase along the new Ib/N function.
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The Solow Model
The Solow Model
• The adjustment mechanism (continued):
• Fundamental determinants of living standards:
¾ At B, Y/N has increased, K/N has increased, S/N
has increased, and Ib/N has increased.
¾ Slowing the population growth rate means:
¾ At steady state B, ΔY/Y = ΔN/N = ΔK/K.
• A higher capital-labor ratio, K/N,
¾ During the transition period from steady state A to
steady state B:
• A higher output per worker, Y/N, and
• A higher consumption per worker, C/N.
• ΔY/Y > ΔN/N because Y/N was increasing, and
• ΔK/K > ΔN/N because K/N was increasing.
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The Solow Model
The Solow Model
• Fundamental determinants of living standards:
• Fundamental determinants of living standards:
¾ Slowing the population growth rate :
¾ Increasing the productivity growth rate:
• Should reducing population growth be a policy goal?
– Doing so will raise consumption per worker but it will reduce
total output and consumption.
– We have also assumed that the proportion of the population of
working age is fixed which may not be true.
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Effect of a productivity improvement
The Solow Model
Y/N
• The adjustment mechanism:
Y/N = A*f(K/N)
(Y/N)A
¾ An improvement in productivity shifts both the
production and saving functions up.
Ib/N = (n + d)K/N
(S/N)A = (Ib/N)A
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¾ At the original K/N, at (K/N)A, Y/N is now higher.
S/N = s*A*f(K/N)
A
¾ Also at the original K/N, at (K/N)A, S/N is now
greater than Ib/N.
(K/N)A
K/N
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The Solow Model
The Solow Model
• The adjustment mechanism:
• The adjustment mechanism (continued):
¾ Consequently, K/N will increase, causing:
¾ Because of diminishing marginal product of
capital, the increase in S/N is smaller than the
increase in Ib/N for every increase in K/N.
• Y/N to increase along the new production function,
• S/N to increase along the new saving function, and
• Ib/N to increase along the balanced investment function.
¾ Eventually S/N will equal Ib/N at a new, higher
steady state at B.
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The Solow Model
The Solow Model
• The adjustment mechanism (continued):
• Fundamental determinants of living standards:
¾ At B, Y/N has increased, K/N has increased, S/N
has increased, and Ib/N has increased.
¾ An improvement in productivity means:
¾ At steady state B, ΔY/Y = ΔN/N = ΔK/K.
• A higher capital-labor ratio, K/N,
¾ During the transition period from steady state A to
steady state B:
• Higher output per worker, Y/N, and
• Higher consumption per worker, C/N.
• ΔY/Y > ΔN/N because Y/N was increasing, and
• ΔK/K > ΔN/N because K/N was increasing.
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The Solow Model
The Solow Model
• Fundamental determinants of living standards:
• Fundamental determinants of living standards:
¾ Can consumption per worker grow indefinitely?
¾ An improvement in productivity means:
• The saving rate cannot rise forever.
• Productivity improvement directly improves the amount
that can be produced at any capital-labor ratio.
• The population growth rate cannot fall forever.
• The increase in output per worker also increases the
supply of saving, and indirectly causes the long-run
capital-labor ratio to rise.
• Productivity and innovation can always occur.
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The Solow Model
Application: The growth of China
• Fundamental determinants of living standards:
• Population of 1.3 billion people.
¾ So living standards can rise continuously.
¾ A huge labor force with a comparative advantage
in labor-intensive industries where wages are low.
¾The rate of productivity improvement is the
dominant factor determining how quickly living
standards rise.
• A low, but rapidly growing, level of GDP.
¾ About 1/9 of US GDP per capita in 1998.
¾ About 1/7 of US GDP per capita in 2007.
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Real GDP growth in China and the US
Application: The growth of China
• Rapid output growth attributable to:
¾ Saving is very high.
• Current consumption is very low.
• Huge increases in capital investment.
¾ Productivity growth is very rapid.
• Due in part from changing to a market economy.
• Due to adopting foreign technologies through FDI, etc.
¾ Population growth has slowed.
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Application: The growth of China
Application: The growth of China
Y/N
• Will China ever catch up to the U.S.?
Y/N = A*f(K/N)
(Y/N)A
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¾ Problems China faces:
Ib/N = (n + d)K/N
• Weak banking system.
(S/N)A = (Ib/N)A
S/N = s*A*f(K/N)
• Rapidly aging population.
A
• Increasing income inequality.
• Much unemployment in rural areas.
(K/N)A
K/N
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Policies to Raise Long-Run Living Standards
Policies to Raise Long-Run Living Standards
• Policies to increase the saving rate:
• Policies to increase the saving rate:
¾ If private markets are efficient, the government
should not try to change the saving rate.
¾ Increase private saving.
• Raise the real interest rate to encourage saving.
– The response of saving to changes in the real interest rate
seems to be small.
• The private markets’ saving rate represents its optimal
trade-off of present for future consumption.
• Provide tax incentives to encourage saving.
• However, if tax laws or myopia cause an inefficiently
low level of saving, government policy to raise the
saving rate may be justified.
– The response of saving to changes in tax incentives also seems
to be small.
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Policies to Raise Long-Run Living Standards
Policies to Raise Long-Run Living Standards
• Policies to increase the saving rate:
• Policies to raise the productivity growth rate:
¾ Increase government saving.
¾ Improve the infrastructure:
• Reduce the government deficit or run a surplus.
• Infrastructure is the highways, bridges, utilities, dams,
airports, etc.
– Through reduced government purchases or higher taxes.
– Research suggests a link between the amount and quality of
infrastructure and productivity growth.
» But under Ricardian equivalence, tax increases to reduce the
deficit won’t affect national saving.
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Policies to Raise Long-Run Living Standards
Policies to Raise Long-Run Living Standards
• Policies to raise the productivity growth rate:
• Policies to raise the productivity growth rate:
¾ Build human capital:
¾ Encourage research and development:
• Research shows a strong connection between
productivity and human capital.
• Encourage R & D through direct and/or indirect means:
• Government can encourage human capital formation
through educational policies, worker training and
relocation programs, and health programs.
– Government funding of R & D efforts.
• Another form of human capital is entrepreneurial skill.
– Enforcement of patents, trademarks, etc.
– Government tax incentives for R & D activities.
– Government could help by removing barriers like red tape.
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Summary
Summary
• Fundamental determinants of living standards:
• Government can influence living standards
with policies designed to:
¾ The saving rate,
¾ The population growth rate, and
¾ Increase the saving rate,
¾ Productivity growth.
¾ Slow the population growth rate, and/or
¾ Raise the productivity growth rate.
• The productivity growth rate is the dominant
factor in determining how quickly living
standards increase.
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