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Topic 1: Ireland’s long-run economic performance Readings Abel & Bernanke or other macro textbook Chapter on long-run economic growth Solow model and convergence Honohan and Walsh (2002) Blanchard (2002) The Solow Growth Model Also known as the “neoclassical” growth model Interactive experiments available at: http://www.fgn.unisg.ch/eurmacro/tutor/solow_index.html Cobb-Douglas production function Y = A F(K, L) = A Ka L(1-a) Y = Output A = Total Factor Productivity (TFP) K = Capital input L = Labour input TFP (A) A: Also called the “Solow residual” Captures wide range of factors: State of technology Strength of economic and political institutions Input utilization Sectoral composition of output Other stuff Sectoral composition of output A = economy-wide level of productivity Consider an economy with two sectors: 1. Agriculture = low productivity 2. Manufacturing = high productivity If Agriculture shrinks and Manufacturing grows, then A increases a = elasticity of Y w.r.t. K Exercise 1: Prove it! Also: a = capital’s share of output (1<a<0) Exercise 2: Prove it! Per worker version divide by L y = Af(k) = A ka where y = Y/L k = K/L Exercise 3: Prove it! Law of motion for the capital stock: kt+1 = (1-d) kt + it Where: i = investment d = rate of depreciation What happens to the capital stock if it = dkt kt+1 = (1-d) kt + it kt+1 = kt - dkt + it kt+1 = kt Let k* = steady-state capital stock y* = Af(k*) = steady-state output If it > dkt then capital stock is growing If it < dkt then capital stock is shrinking In a closed economy: Investment = Savings i = sy i = sAf(k) where s = savings rate Convergence Conditional convergence If two countries have the similar A and s, but different initial k, then they will converge If a SOE, then s not important Absent obstacles, A’s shouldn’t be very different across advanced economies Evidence of conditional convergence among advanced economies Honohan and Walsh (2002) 1990s boom was a convergence story Convergence telescoped into one decade No single factor accounts for 1990s boom Why didn’t Ireland converge sooner? Institutional preconditions for such convergence already present in 1973, but fiscal policy errors in the 1970s derailed convergence Honohan and Walsh (2002) Why was convergence in the 1990s so rapid? How do we explain the employment boom? Non-agricultural employment as share of population 40 35 30 25 20 60 65 70 75 80 85 90 Source: Honohan and Walsh (2002) 95 00 Table 1: Ireland’s employment share and productivity relative to UK, 1973 Ireland UK Ireland As % of UK Apparent Productivity (£ per head) GDP per person at work Agricultural output per person at work Non-agricultural output per person at work GDP per head of population 2 380 1 634 2 605 856 2 642 2 726 2 640 1 173 90 60 99 73 Employment shares (%) Employment in agriculture as % total Total employment as % population Non-agricultural employment as % population 23.2 36.0 27.6 3.0 44.4 43.1 780 81 64 Source: Ireland: ESRI database; UK: Annual Abstract of Statistics, 1985 edition; OECD National Income Accounts. Note: “Agriculture” includes forestry and fisheries. The difference between GDP and GNP in 1973 was small. Source: Honohan and Walsh (2002) Fiscal Errors See Figure 3: Budgetary Aggregates See Figure 4: Marginal and Average Income Tax Rates, 1979-2002 Unfavorable external conditions Table 2: External conditions in the 1980s UK GDP Growth % per annum US $ short interest rate % 1981-84 1.8 12.0 1986-89 4.1 7.6 Source: Honohan and Walsh (2002) Blanchard (2002) • • • Key factor behind boom: Wage moderation Wage moderation = “wage growth below the rate consistent with technological progress.” Low wage growth lower costs higher profits higher K and L Blanchard (2002) Recall: Y = A F(K, L) = A Ka L(1-a) Marginal product of labour (MPL) MPL = DY/DL = (1-a)A F(K, L)/L From micro, we know that firms choose L to equate the MPL to the market wage rate So, for the whole economy: w = (1-a)A F(K, L)/L w/A = (1-a) F(K, L)/L w/A = (1-a) (K/L)a Exercise 4: Prove it! If w/A falls, then K/L must fall But K rises due to higher profits So L must boom! So wage restraint boosts investment and especially employment Sources of wage restraint Social partnership agreements High unemployment Natural demographics Immigration Income tax cuts Why did wage moderation have such a large effect in Ireland? Openness of economy amount of K took the form of Foreign Direct Investment (FDI) Migration flows Available export markets Notable No “crowding out” Reading for next lecture Ahearne, Kydland, and Wynne (2005) Barry (2002) Fitz Gerald (2004)