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Chapter 7: Growth Effects & Factor Market Integration © Baldwin&Wyplosz The Economics of European Integration 1 Growth Effects • European leaders have long emphasised a the pro-growth aspects of European integration • These operate in a way that is fundamentally different from the way allocation effects operate; • they operate by changing the rate at which new factors of production – mainly capital – are accumulated, – hence the name ‘accumulation effects’. © Baldwin&Wyplosz The Economics of European Integration 2 Verbal logic of growth • Growth in income per worker requires more output per worker. • Nation's labour force can produce more goods and services year after year only if they have more/better 'tools' year after year. – 'tools' means capital broadly defined: • physical capital (machines, etc.), • human capital (skills, training, experience, etc.) and • knowledge capital (technology). • ERGO, rate of output growth is linked to rate of physical, human and knowledge capital accumulation. • Most capital accumulation is intentional and it is called investment. – Thus: European integration affects growth mainly via its effect on investment in human capital, physical capital and knowledge capital. © Baldwin&Wyplosz The Economics of European Integration 3 Verbal logic of growth: summary • European integration (or any other policy) → allocation effect → improved efficiency → better investment climate → more investment in machines, skills and/or technology → higher output per person. • * Medium run effects eventually fade out – Growth returns to its long-run rate • Long run effects raise long-run rate forever © Baldwin&Wyplosz The Economics of European Integration 4 Some facts Table 7-1: European Growth Phases, 1890-1992 Period Real GDP 2.6 Real GDP per capita 1.7 Real GDP per hour 1.6 1890-1913 Belle epoque 1913-1950 2nd 30 yr war 1950-1973 Golden era 1973-1992 1.4 1.0 1.9 4.6 3.8 4.7 2.0 1.7 2.7 2.5 1.9 2.6 Prod’ity slowdown Whole Period 1890-1992 © Baldwin&Wyplosz The Economics of European Integration 5 Some facts Table 7-2: Growth in the WWII Reconstruction Phase. The Set-Back: (Prewar year when GDP equalled that of 1945) Back-on-Track Year (Year GDP attained highest pre-war level) Reconstruction Growth (rate 1945 to col. 2 year) Austria 1886 1951 15.2% Belgium 1924 1948 6.0% Denmark 1936 1946 13.5% Finland 1938 1945 n.a. France 1891 1949 19.0% Germany 1908 1951 13.5% Italy 1909 1950 11.2% Netherlands 1912 1947 39.8% Norway 1937 1946 9.7% Sweden These nations grew during WWII Switzerland UK © Baldwin&Wyplosz The Economics of European Integration 6 Some facts Table 7 3: GDP per capita & Rankings, 1950 and 1973 (1990 international dollars). EEC average EFTA average France Germany Italy UK 1950 GDP (1990 $) European Rank 1950 Change in GDP Rank 1950- Growth 1973 Rate 4,825 8.0 + 1.2 4.2 6,835 3.6 -1.4 3.0 5,221 4,281 3,425 6,847 7 9 13 2 +2 +5 +2 -5 4.0 5.0 4.9 2.4 © Baldwin&Wyplosz The Economics of European Integration 7 Some facts Complete table 1950 GDP (1990 $) European Rank 1950 Change in Rank 1950-1973 GDP Growth Rate EEC average 4,825 8.0 + 1.2 4.2 Netherlands 5,850 5 -1 3.4 Belgium 5,346 6 -2 3.5 France 5,221 7 +2 4.0 Germany 4,281 9 +5 5.0 Italy 3,425 13 +2 4.9 EFTA average 6,835 3.6 -1.4 3.0 Switzerland 8,939 1 0 3.1 UK 6,847 2 -5 2.4 Sweden 6,738 3 +1 3.1 Denmark 6,683 4 +1 3.1 Norway 4,969 8 -4 3.2 Finland 4,131 10 0 4.2 Austria 3,731 11 +2 4.9 Others average 2,401 14.3 -0.3 5.2 Ireland 3,518 12 -3 3.1 Spain 2,397 14 +1 5.8 Portugal 2,132 15 +1 5.6 Greece 1,558 16 0 6.2 For Comparison USA 9,573 Japan 1,873 2.4 8.0 © Baldwin&Wyplosz The Economics of European Integration 8 Solow diagram • Show medium run growth effects in simple diagram • To simplify, start with whole EU as a single, closed economy with fully integrated capital and labour markets and the same technology everywhere. © Baldwin&Wyplosz The Economics of European Integration 9 Solow diagram euros/L The inflow of new capital and how it varies with K/L Outflow of capital per L, constant depreciation rate, delta Y/L* GDP/L B d(K/L) s(GDP/L) A Assume fixed investment rate, s Io Do K/Lo K/L* K/L © Baldwin&Wyplosz The Economics of European Integration 10 Induced capital formation euros/L Y/L’ Y/Lc Y/L* Induced capital formation effect, i.e. medium-run growth bonus E C GDP/L’ GDP/L Allocation effect d(K/L) B D s(GDP/L)’ s(GDP/L) A K/L* K/L’ K/L © Baldwin&Wyplosz The Economics of European Integration 11 Maths – neoclassical I • • • • • • • Solow model’s constant savings rate S/L=s*Y/L, but Deprec/L=d*(K/L) Y/L=A*(K/L)a; define K/L as k Equilibrium: K/L s.t. s*A*(k)a=d*(k) dA/A+adk/k=dk/k => (dk/k)/(dA/A)=1/(1-a) So d(Y/L)/(dA/A)=1+ a/(1-a) The ‘1’ is the allocation effect, the ‘a/(1-a)’ is the medium-run growth bonus, i.e. accumulation effect. © Baldwin&Wyplosz The Economics of European Integration 12 Maths – neoclassical II • Allow intertemporal optimisation • Steady state condition is: rho + delta = aA*(k)a-1 So (dk/k)/(dA/A)=1/(1-a) • So we get same result as with the Solow Model . © Baldwin&Wyplosz The Economics of European Integration 13 Integration induced investment rate rise euros/L Medium-run growth bonus D Y/L’ Y/L* GDP/L d(K/L) B C s’(GDP/L) s(GDP/L) A K/L* K/L’© Baldwin&Wyplosz The Economics of EuropeanK/L Integration 14 OtherExperience MR growthofeffects: investment Spain & Portugal rate © Baldwin&Wyplosz The Economics of European Integration 15 Other MRExperience growth effects: investment rate of Ireland © Baldwin&Wyplosz The Economics of European Integration 16 Other MRExperience growth effects: investment rate of Greece © Baldwin&Wyplosz The Economics of European Integration 17 Long-term growth in Solow-like diagram euros/L GDP/L Y/L* s(GDP/L) A d(K/L) B K/L* K/L =Knowledge/L © Baldwin&Wyplosz The Economics of European Integration 18 Maths - New growth theory • Endogenous product innovation; drives growth as Prices fall with n. • Basic setup explained. – Costs aI units of labour to develop a new variety which lasts forever. – Discounting at ‘r’ – Euler equation says: growth rate of E = r – r – r is the subjective discount rate of infinately lived consumer. • dn=LI/aI,; • Knowledge spillovers, so aI=1/n, i.e. amt of labour to invent a new variety rises as cumulative experience in innovation rises. © Baldwin&Wyplosz The Economics of European Integration 19 Maths - New growth theory • Endogenous product innovation; what’s the MC and MB of introducing a new variety? CLOSED ECONOMY TO START WITH. • Flow benefit = operating profit; with Dixit-Stiglitz • p=(1/s)E(market share). – E is expenditure, sigma is CES elasticity – In a closed economy, market share =1/n. • Present value of flow of operating profits is: – Integral of E/(sn) from t=0 to infinity discounted at ‘r’ when n is growing at constant endogenous rate ‘g’. © Baldwin&Wyplosz The Economics of European Integration 20 Maths - New growth theory • Take LI as the state variable and labour as numeraire so w=1. • Since L=LI+LE, we know in steady state that the amount of labour devoted to consumption goods must be time invariant in steady state, so dE/E must stop evolving, thus r = rho in steady state. • PDV of operating profits equals. • MB=(E/(sno))(1/(rho+g)) – dn/n defined as ‘g’ growth rate of varieties • MC=w/no but w=1, • NB: E = income-investment = wL+np-wLI = wL+E/s-wLI => E=(L-LI)/(1-1/s) © Baldwin&Wyplosz The Economics of European Integration 21 Maths - New growth theory • • • • MB=MC (((L-LI)/(1-1/s))/(s)) (1/(rho+g))=1 (L-g)/(s-1)=r+g Solve for g: – g = (L-(s-1)r)/s • Freer trade from no trade with identical nations; L doubles so g rises and thus growth rate rises • This is a long-run growth effect. © Baldwin&Wyplosz The Economics of European Integration 22 Long-term growth impact of integration euros/L Integration improves efficiency → improves investment climate → higher investment rate (s rises to s’) → faster growth (knowledge capital accumulates more rapidly) GDP/L s’(GDP/L) Y/L* s(GDP/L) C A d(K/L) B K/L* K/L =Knowledge/L © Baldwin&Wyplosz The Economics of European Integration 23