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Macroeconomics ECO 403

LESSON 23

ECONOMIC GROWTH (Continued...)

2. Policies to increase the saving rate

Reduce the government budget deficit

(or increase the budget surplus)

Increase incentives for private saving:

Reduce capital gains tax, corporate income tax, estate tax as they discourage saving

Replace federal income tax with a consumption tax

Expand tax incentives for individual retirement accounts and other retirement savings

accounts

3. Allocating the economy's investment

In the Solow model, there's one type of capital.

In the real world, there are many types,

which we can divide into three categories:

Private capital stock

Public infrastructure

Human capital: the knowledge and skills that workers acquire through education

How should we allocate investment among these types?

Two viewpoints

1. Equalize tax treatment of all types of capital in all industries, and then let the market

allocate investment to the type with the highest marginal product.

2. Industrial policy: Govt. should actively encourage investment in capital of certain types

or in certain industries, because they may have positive externalities (by-products) that

private investors don't consider.

Possible problems with industrial policy

Does the govt. have the ability to "pick winners" (choose industries with the highest return to

capital or biggest externalities)?

Would politics rather than economics influence which industries get preferential treatment?

4. Encouraging technological progress

Patent laws:

encourage innovation by granting temporary monopolies to inventors of new products

Tax incentives for R&D

Grants to fund basic research at universities

Industrial policy:

encourage specific industries that are key for rapid tech. progress

(subject to the concerns on the preceding slide)

Macroeconomics ECO 403

Growth empirics: Confronting the Solow model with the facts

Solow model's steady state exhibits balanced growth - many variables grow at the same rate.

Solow model predicts Y/L and K/L grow at same rate (g), so that K/Y should be

constant. This is true in the real world.

Solow model predicts real wage grows at same rate as Y/L, while real rental price is

constant. Also true in the real world.

Convergence

Solow model predicts that, other things equal, "poor" countries (with lower Y/L and K/L )

should grow faster than "rich" ones.

If true, then the income gap between rich & poor countries would shrink over time, and

living standards "converge."

In real world, many poor countries do NOT grow faster than rich ones. Does this mean the

Solow model fails?

· No, because "other things" aren't equal.

In samples of countries with similar savings & population growth rates,

income gaps shrink about 2%/year.

In larger samples, if one controls for differences in saving, population growth, and

human capital, incomes converge by about 2%/year.

What the Solow model really predicts is conditional convergence - countries converge to

their own steady states, which are determined by saving, population growth, and education.

And this prediction comes true in the real world.

Factor accumulation vs. Production efficiency

Two reasons why income per capita are lower in some countries than others:

1. Differences in capital (physical or human) per worker

2. Differences in the efficiency of production (the height of the production function)

Studies:

· Both factors are important

· Countries with higher capital (phys or human) per worker also tend to have higher

production efficiency

Explanations:

· Production efficiency encourages capital accumulation

· Capital accumulation has externalities that raise efficiency

· A third, unknown variable causes cap accumulation and efficiency to be higher in some

countries than others

Endogenous Growth Theory

Solow model:

Sustained growth in living standards is due to tech progress

The rate of tech progress is exogenous

Macroeconomics ECO 403

Endogenous growth theory:

a set of models in which the growth rate of productivity and living standards is

endogenous

A basic model

Production function: Y = A K

where A is the amount of output for each unit of capital (A is exogenous & constant)

Key difference between this model & Solow: MPK is constant here, diminishes in Solow

Investment: s Y

Depreciation: δ K

Equation of motion for total capital:

ĆK = s Y - δ K

· Divide through by K and use Y = A K , get:

ΔY

ΔK

= sA - δ

· If s A >δ, then income will grow forever, and investment is the "engine of growth."

· Here, the permanent growth rate depends on s. In Solow model, it does not.

Does capital have diminishing returns or not?

Yes, if "capital" is narrowly defined (plant & equipment).

Perhaps not, with a broad definition of "capital" (physical & human capital, knowledge).

Some economists believe that knowledge exhibits increasing returns.

In the endogenous growth model, the assumption of constant returns to capital is more

plausible.

A two-sector model

Two sectors:

Manufacturing firms produce goods

Research universities produce knowledge that increases labor efficiency in

manufacturing

u = fraction of labor in research (u is exogenous)

Manufacturing production function: Y = F [K, (1-u) E L]

Research production function: Ć E = g (u) E

Cap accumulation: Ć K = s Y - δ K

In the steady state, manufacturing output per worker and the standard of living grow at rate

ΔE/E = g (u ).

Key variables:

Macroeconomics ECO 403

affects the level of income, but not its growth rate (same as in Solow model)

affects level and growth rate of income

Question:

Would an increase in u be unambiguously good for the economy?

Three facts about R&D in the real world

1. Much research is done by firms seeking profits

2. Firms profit from research because

· New inventions can be patented, creating a stream of monopoly profits until the

patent expires

· There is an advantage to being the first firm on the market with a new product

Innovation produces externalities that reduce the cost of subsequent innovation.

Much of the new endogenous growth theory attempts to incorporate these facts into models to

better understand tech progress.

Is the private sector doing enough R&D?

The existence of positive externalities in the creation of knowledge suggests that the private

sector is not doing enough R&D.

But, there is much duplication of R&D effort among competing firms.

Estimates: The social return to R&D is at least 40% per year.

Thus, many believe govt should encourage R&D.

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