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MACROECONOMICS AND THE GLOBAL BUSINESS ENVIRONMENT Capital Accumulation, Technological Progress, and Economic Growth 1 PowerPoint by Beth Ingram University of Iowa Copyright © 2005 John Wiley & Sons, Inc. All rights reserved. 4-2 Key Concepts Definition of Capital and Investment Decreasing Marginal Return Convergence in Rates of Growth The Steady State 4-3 Real GDP (billions of 1996 $) Decreasing marginal product An increase in the quantity of labor increases Real But growth GDP rate decreases as labor increases 15 12 6 500 1000 1500 Labor Hours 4-4 Real GDP (billions of 1996 $) Decreasing marginal product An increase in the quantity of capital increases Real But growth GDP rate decreases as capital increases 15 12 6 500 1000 1500 Quantity of Capital 4-5 Diminishing Marginal Return Growth will be fast when level of capital is low Growth slows down as capital accumulates Eventually, firms won’t add new capital – firms only replace depreciated capital Economy reaches a Steady State Growth Convergence The return from capital for developing countries should be higher (everything else held constant) than wealthy countries “Catch Up” (graph) 4-6 Optimal Investment Value of new capital is (Marginal Product) x (Price of Output) Suppose 6 units x $2 = $12 Cost of new capital Denoted by r+d r = interest rate Assume resell capital and payoff principal d = wearing out of capital or depreciation Taxes may also be important Invest in new capital if Equilibrium: MP x Price of output = r If MP x Price of output > r…then keep investing in capital until equalized If MP x Price of output < r…put investment into financial market until equalized 4-7 In equilibrium… Interest Rate Savings 6% 5% Investment 5% 10% 12% Percentage of Income 4-8 In equilibrium… Interest Rate Savings 5% 4% Investment 10% 14% Percentage of Income 4-9 Suppose increase in TFP r Savings 6% 5% Investment 10% 12% Percentage of Income 4-10 Suppose declining savings Interest Rate Savings 5.5% 5% Investment 8% 10% Percentage of Income 4-11 Capital (K) Capital formation comes from Investment Capital is the total value of the machines and buildings used to produce output Capital depreciates (wears out) Assume constant rate of depreciation, d Assume depreciation is fraction of capital stock, d*K 4-12 Steady State The point where a country can no longer economically grow by adding more capital A resting point for capital stock Capital can temporarily deviate away, but always comes back A equilibrium point for the model Holding labor and productivity fixed Changes in the capital stock come from (1) new capital and (2) replacing old depreciated capital Gross investment = (1) + (2) Net Investment = (1) Kt = Kt-1 + It + Dt (Where Dt = d*Kt-1 and It = b*Yt; 0<d,b<1) Stead state: Kt = Kt-1 which implies It = Dt 4-13 Steady State Real GDP Output C+G+X-M Investment Investment (20% of GDP) Capital Stock 4-14 Steady State Real GDP Investment = Depreciation Output Depreciation = d x Capital Stock Investment Capital Stock 4-15 Depreciation exceeds investment; capital stock must increase Output Real GDP Depreciation Investment KLow Kss KHigh Capital Stock 4-16 Investment exceeds depreciation; capital stock must decline Output Real GDP Depreciation Investment KLow Kss KHigh Capital Stock 4-17 Implications Since capital is limited, growth must ultimately come from productivity If all countries eventually have same access to technology and other factors driving productivity then all countries should grow at the same rate Consequently, how much one country is investing will not affecting the growth rate i.e. in the long run, a country’s growth rate is independent of its investment Investment will, however, affect level of output 4-18 Increase in Investment Rate Output Real GDP Depreciation Investment (30% of GDP) Investment (20% of GDP) K20% K30% Capital Stock 4-19 The Asian Miracle Why did Asian economies grow so fast after 1950? Can this experience be repeated elsewhere? 4-20 Growth Accounting Asian Tigers, 1966 - 1990 4-21 Growth accounting in emerging markets, 1960–1994. 4-22 Growth Accounting 1960-1990 Real GDP Growth Population Growth Capital Growth Brazil 3.60% 2.40% 3.00% Mexico 4.90% 2.70% 3.20% Singapore 8.40% 6.40% 11.30% Contribution to Real GDP Growth TFP Population Capital Sum to Real GDP Growth Brazil Mexico Singapore 1.02% 1.68% 0.90% 3.60% 2.05% 1.89% 0.96% 4.90% 0.53% 4.48% 3.39% 8.40% 4-23 Does source of growth matter? Higher growth means higher standard of living Growth through capital accumulation Eventually dissipates Comes at a cost (low consumption in previous generations) Modern economies started industrializing around 150 years ago…why haven’t they reached their steady state? Transition to TFP-induced growth? 4-24 Effect of an increase in TFP Real GDP Production Function, New Production Function, Old Depreciation Investment, New Investment, Old K0 K1 Capital 4-25 Production Function Shift Summarizing Increase in Output due to function shift Increase in Labor Increase in TFP Increase in Output due to increase in capital Economy moves to new steady state As capital increases, output increases 4-26 TFP Institutions Property Rights Regulatory Institutions Macroeconomic Stabilization Social Insurance Conflict Management Political Rights Trust/Social Capital Culture of Risk Taking and Entrepreneurship Technology Gains 4-27 TFP Institutions: Caribbean Example 2007 World Bank report: Crime, Violence, and Development: Trends, Costs, and Policy Options in the Caribbean 4-28 4-29 4-30 4-31 4-32 TFP: Institutions Gone Awry ---Rent Seeking Activity in which value-added produced by one person is taken by another Examples U.S. Farm subsidies Concerns Absorbs resources (labor and capital) Rent seeking crowds out production Weakens social capital/breeds corruption 4-33 TFP: Technological Progress Another important driver in TFP not necessarily independent of institutions Growth can be sustained through technological progress Continued gains to productivity Role of Research and Development in promoting technological progress 4-34 TFP: Technological Progress R&D per Capita, 1997 Rich countries spend more on R&D 800 600 400 200 0 0 5000 10000 15000 20000 25000 30000 35000 GDP per Capita, 1997 4-35 4-36 Aside: Human Capital Capital can be broken down into physical and human capital Increase human capital means more output, even at current levels of physical capital and labor means higher steady state level of output and capital May explain some cross-country growth differentials 4-37 Aside: Human Capital Percentage of students completing the final year of primary school Source: World Bank Millennium Development Goals 4-38 Summary Marginal Product of Capital Implications of decreasing MPK Role in determining Steady State Steady State Investment Investment = Depreciation Growth can no longer be achieved through investment TFP Institutions Technological progress