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ECONOMIC GROWTH (Continued…):Possible problems with industrial policy

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Macroeconomics ECO 403
VU
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)
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Macroeconomics ECO 403
VU
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
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Macroeconomics ECO 403
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·
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
=
Y
K
· 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:
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Macroeconomics ECO 403
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s:
affects the level of income, but not its growth rate (same as in Solow model)
u:
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
3.
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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Table of Contents:
  1. INTRODUCTION:COURSE DESCRIPTION, TEN PRINCIPLES OF ECONOMICS
  2. PRINCIPLE OF MACROECONOMICS:People Face Tradeoffs
  3. IMPORTANCE OF MACROECONOMICS:Interest rates and rental payments
  4. THE DATA OF MACROECONOMICS:Rules for computing GDP
  5. THE DATA OF MACROECONOMICS (Continued…):Components of Expenditures
  6. THE DATA OF MACROECONOMICS (Continued…):How to construct the CPI
  7. NATIONAL INCOME: WHERE IT COMES FROM AND WHERE IT GOES
  8. NATIONAL INCOME: WHERE IT COMES FROM AND WHERE IT GOES (Continued…)
  9. NATIONAL INCOME: WHERE IT COMES FROM AND WHERE IT GOES (Continued…)
  10. NATIONAL INCOME: WHERE IT COMES FROM AND WHERE IT GOES (Continued…)
  11. MONEY AND INFLATION:The Quantity Equation, Inflation and interest rates
  12. MONEY AND INFLATION (Continued…):Money demand and the nominal interest rate
  13. MONEY AND INFLATION (Continued…):Costs of expected inflation:
  14. MONEY AND INFLATION (Continued…):The Classical Dichotomy
  15. OPEN ECONOMY:Three experiments, The nominal exchange rate
  16. OPEN ECONOMY (Continued…):The Determinants of the Nominal Exchange Rate
  17. OPEN ECONOMY (Continued…):A first model of the natural rate
  18. ISSUES IN UNEMPLOYMENT:Public Policy and Job Search
  19. ECONOMIC GROWTH:THE SOLOW MODEL, Saving and investment
  20. ECONOMIC GROWTH (Continued…):The Steady State
  21. ECONOMIC GROWTH (Continued…):The Golden Rule Capital Stock
  22. ECONOMIC GROWTH (Continued…):The Golden Rule, Policies to promote growth
  23. ECONOMIC GROWTH (Continued…):Possible problems with industrial policy
  24. AGGREGATE DEMAND AND AGGREGATE SUPPLY:When prices are sticky
  25. AGGREGATE DEMAND AND AGGREGATE SUPPLY (Continued…):
  26. AGGREGATE DEMAND AND AGGREGATE SUPPLY (Continued…):
  27. AGGREGATE DEMAND AND AGGREGATE SUPPLY (Continued…)
  28. AGGREGATE DEMAND AND AGGREGATE SUPPLY (Continued…)
  29. AGGREGATE DEMAND AND AGGREGATE SUPPLY (Continued…)
  30. AGGREGATE DEMAND IN THE OPEN ECONOMY:Lessons about fiscal policy
  31. AGGREGATE DEMAND IN THE OPEN ECONOMY(Continued…):Fixed exchange rates
  32. AGGREGATE DEMAND IN THE OPEN ECONOMY (Continued…):Why income might not rise
  33. AGGREGATE SUPPLY:The sticky-price model
  34. AGGREGATE SUPPLY (Continued…):Deriving the Phillips Curve from SRAS
  35. GOVERNMENT DEBT:Permanent Debt, Floating Debt, Unfunded Debts
  36. GOVERNMENT DEBT (Continued…):Starting with too little capital,
  37. CONSUMPTION:Secular Stagnation and Simon Kuznets
  38. CONSUMPTION (Continued…):Consumer Preferences, Constraints on Borrowings
  39. CONSUMPTION (Continued…):The Life-cycle Consumption Function
  40. INVESTMENT:The Rental Price of Capital, The Cost of Capital
  41. INVESTMENT (Continued…):The Determinants of Investment
  42. INVESTMENT (Continued…):Financing Constraints, Residential Investment
  43. INVESTMENT (Continued…):Inventories and the Real Interest Rate
  44. MONEY:Money Supply, Fractional Reserve Banking,
  45. MONEY (Continued…):Three Instruments of Money Supply, Money Demand