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EC111 MACROECONOMICS Spring Term 2012

Lecturer: Jonathan Halket
Week 24
Topic 9: ECONOMIC GROWTH AND DEVELOPMENT
Begg Chapter 26.
We have been concerned so far with short run adjustments to national income, which
affect the utilisation of the economys resources. In the long rundecades rather than
yearswe are more concerned with the growth of the productive capacity of the
economy.
Per capita GDP Multiples and Annual Growth rates

1950/1870
Growth
rate % 2006/1950
Growth
rate %
Austria 2 0.9 6.1 3.2
Belgium 2 0.9 4.2 2.6
Denmark 3.5 1.6 3.6 2.3
Finland 3.7 1.6 5.5 3.0
France 2.8 1.3 4.5 2.7
Germany 2.1 0.9 5.2 2.9
Italy 2.3 1.0 5.7 3.1
Netherlands 2.2 1.0 3.9 2.4
Norway 4 1.7 5.1 2.9
Sweden 4.1 1.8 3.6 2.3
Switzerland 4.3 1.8 2.6 1.7
United Kingdom 2.2 1.0 3.3 2.1
Ireland 1.9 0.8 8.1 3.7
Greece 2.2 1.0 8.2 3.8
Portugal 2.1 0.9 6.8 3.4
Spain 1.8 0.7 8.6 3.8
Australia 2.3 1.0 3.3 2.1
New Zealand 2.7 1.2 2.2 1.4
Canada 4.3 1.8 3.4 2.2
United States 3.9 1.7 3.2 2.1

We noted before that modest growth rates can cumulate to large multiples in per capita
income over decades.
Note that, even in the developed world there are large differences in growth rates and
therefore in income multiples. Note the slow growth of the UK after 1950 as compared
with Greece or Ireland.

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A model of economic growth
We shall assume that the economy is close to full employment. The three main sources
of growth in total output are:
Labour force growth (more precisely the number of worker hours)

Growth of the capital stock

Technical progress (the growth of output per unit of factor inputs)
Other sources of economic growth such as increases in land and, in particular,
education and training will be ignored (or subsumed under the other headings).
We can write the aggregate production function as:

Thus real national income, Y, is produced by fully employing the available stock of
capital and labour. T is the overall productivity or efficiency with which these factors
produce output. This is directly analogous to the production function of the individual
firm, but at the national level.
We can draw a production isoquant for the economy as a whole. Recall that this shows
the combinations of labour and capital that can produced a given level of output.













K



K
2


K
1


Slope = (W/R)
1

Y
1
L
1
L
Y
2
Slope = (W/R)
2

3

With factors L
1
and K
1
the economy can produce and output level Q
1
. Note that in
order to ensure that both factors are fully employed the factor price ratio must be
(W/R)
1
where W and R are the factor prices of capital and labour. This is the slope of a
line tangent to the production function.
If the stock of capital increased to K
2
then full employment output would be Q
2
. Note
that to ensure that capital is fully employed the factor price of capital must fall (because
there are diminishing returns) and so the factor price line becomes steeper.

For the moment we ignore technical progress and we write the production function in
per-worker form, sometimes called intensive form.
____________________________














Income or output per worker is a function of capital per worker. The production
function exhibits diminishing returns to capital and its slope is the marginal product of
capital which is equal to the factor price of capital, R.

y



y
1





y = f(k)
k
1
k
Slope = R
4

In order to build a basic growth model we exclude the government and international
trade and we have a simple proportional savings function:

In per-worker form:
__________________
Savings is equal to investment in this economy and we ignore depreciation so that
investment is equivalent to the addition to the capital stock. (Note that in our
macroeconomic analysis so far we have ignored the link between investment and
productive capacity.)

In per-worker terms:
_____________________
The change in the capital to labour ratio can be written as:
1


This says that the changein the capital to labour ratio is due to two things:
The change in the stock of capital per initial worker

The growth of the labour force times initial capital per worker.


1
Note that the rate of growth of K/L is (or k) is the difference between the growth rate of capital
and the growth rate of labour:

Multiplying both sides by k we have:

Which is simply:

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Let the growth rate of labour supply be

= n (the natural growth rate of the

population).
And remembering that:

= sf(k), we can write:

This is the fundamental neoclassical growth equation. It is sometimes called the Solow
model. What it says is that if savings per worker, sf(k), is greater than the amount
needed to provide all the additional workers with the same amount of capital as all
previous workers, nk, then the capital/labour ratio will be increasing: k > 0. In this
case each worker will have an increasing amount of capital to work withso called
capital deepening.

The growth rate (in proportional terms) is the difference between the growth rate of
capital and the growth rate of labour













On the diagram sf(k) is simply the production function f(k) multiplied by s, and so it is
the same shape. nk is a straight line with slope n.
y

y*

y
1





y = f(k)
k
1
k* k
sy = sf(k)
nk
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Suppose that the economy had an initial capital to labour ratio of k
1
. Savings per
worker exceeds the amount necessary to provide the growth in the labour force with
capital per worker k
1
. Therefore k must be positive and k will move towards k*. At k*
nk and sf(k) are equal and so there is no change in k.
This is the steady state growth path. At k* capital, labour and output are all growing at
the same rate, n. Question: how do we know this?
During the transition from k
1
to k* income per capita will increase from y
1
to y*. But
once the economy settles at k* there will no further growth in per capita income. This is
because we have no technical progress in the model (yet).

Will an increase in the savings rate, s, lead to higher growth?














Starting from steady state growth at k*
1
the savings rate increases from s
1
to s
2
. Now k
will be rising towards the new steady state at k*
2
. In the transition, income per capita
will increase but once the economy settles at the new steady state there will be no
further increase in per capita income. In the new steady state income per capita will be
higher in absolute terms but Y, K, and L will all be growing at rate n as before under
the old steady state.
y
y*
2

y*
1





y = f(k)
k*
1
k*
2
k
s
1
y = s
1
f(k)
nk
s
2
y = s
2
f(k)
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The message of the neoclassical (Solow) growth model is that, in the absence of technical
progress income per capita only grows in the transition to the steady state. Steady state
growth is the same in all steady states.
But suppose we could choose the savings ratio, s. Which is the best steady state to be
in?













Remember that Y = C + I. In per capita terms:
__________________
As we move along nk we want to find the largest distance between y = f(k) and nk. This
is where a tangent to the production function is just parallel to the line nk. The tangent
represents the factor price of capital R (sometimes just thought of as the interest rate).
This is the golden rule: to maximize consumption per head the factor price of capital (or
the interest rate r) is equal to the natural growth of the labour force, n.
All steady states are therefore not equally good. If the savings rate was higher than that
in the diagram consumption per capita would be lower. This is because income per
capita does not increase by as much as the additional saving that is necessary to produce
it.
y

y**




y = f(k)
k** k
sy = sf(k)
nk
slope

= R
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Technical progress
In the basic model we have excluded technical progress. But this is perhaps the most
important source of growth. If we allow for technical progress then growth in income
per capita will occur even in the steady state.
Technical progress means growth in efficiency. More output for a given input, or less
input for a given output. This can arise in a variety of ways; through the application of
scientific discoveries, or from finding better ways of working.
We assume that technical progress is labour augmenting. It is as if the labour power
of each worker increases at e.g. 2 percent per annum. So a given number of workers
supply more effective labour units as time elapses. We define effective labour as:
________________
For each worker labour power grows at an exponential rate g per unit of time (t), where
e is the exponential constant. Thus:
______________________

Now we simply redefine output per worker, y, and capital per worker, k , in terms of
effective labour.
_______________________
The neoclassical growth equation can now be written in terms of effective labour units.

The diagram is exactly the same as before except that everything is now defined in
terms of effective labour.
In the steady state capital and output now grow at the same rate as effective labour
units, g. In the steady y and k are constant but K/L (k) and Y/L (y) grow at rate g. So
in this version of the neoclassical growth model there is growth in per capita income in
the steady state.
As before if the economy was out of the steady state at k
1
, then capital per effective
worker would grow as the economy moved towards the steady state. In the transition,
income per capita will grow faster than g and then it will settle at g in the steady state.



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Human Capital
One important input so far ignored is human capital, or skills. As people become more
skilled and educated they become more productive. As workers accumulate more
human capital labour quality increases. Workers with better skills and qualifications
command a higher wage, which is a reflection of this quality.
This is equivalent to an increase in effective labourthe increase in the labour supply
when we allow for improved quality. If the skills of the labour force grow in the long
run then this is equivalent to an increase in g.
In practice improvements in the quality of labour and capital may be complimentary.
Having offices full of modern computers is not much use if there is no-one with the skills
to use them effectively.

y

y*

y
1





y = f(k)
k
1
k* k
sy = sf(k)
(g + n)k
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Why growth rates differ
There has been a great deal of interest in analysing the sources of differences in growth
rates. Here are three questions:
What are the sources of differences between countries in growth rates of per
capita income?
Do different growth rates result in convergence the convergence of per capita
income levels?
Are there other factors such as government policies that account for differences
between countries?



The graph here (for the countries listed in the table on p. 1) plots the proportionate
increase (or multiple) in national income between 1950 and 2006 (3
rd
column on p. 1) of
each country against its income level in 1950 (all measured in 1990 US dollars).
Countries that were relatively poor (Spain Portugal Greece Ireland) grow faster; those
with high income in 1950 Canada, the US, to a lesser extent Britain) grow more slowly.
So income levels have tended to converge. Why is this?


0
1
2
3
4
5
6
7
8
9
10
0 2,000 4,000 6,000 8,000 10,000 12,000
G
r
o
w
t
h

M
u
l
t
i
p
l
e

1950 per capita income (in $1990)
Growth and 1950 Income per Capita
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Non- steady state growth













Countries with a particularly low k (and therefore a low y) at the beginning of the
period will be moving towards the steady state. Thus they will benefit from higher
growth rates of per capita income in the transition to the steady state. This would be
especially true of countries whose capital stock was largely destroyed in the second
World War (e.g. Germany, Japan), relative to say the US.
Savings rates also increased so almost all countries benefited from some non-steady
state growth.
We should also expect to see a slowing down in growth rates. This may be one reason
why growth in many European countries was slower in the last 25 years than the
previous 25 years.
Technological catch-up and human capital
Some economists argue that the main reason for convergence is that technical progress
has been faster in poorer countries. They have made large productivity gains by
adopting new technology from the leader countries, especially the US. The best
practice methods of production are adopted either by introducing American (or
German or Japanese) machinery or equipment, by employing scientists and technicians
y

y*

y
1





y = f(k)
k
1
k* k
sy = sf(k)
(g + n)k
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from the leading countries or by sending students or employees to learn new methods
and techniques.
Note that this would mean an increase in g. On the other hand labour force growth has
been slow so n has slowed down. As we have seen, in the steady state, higher g means
higher growth in per capita income. But as countries catch up with the frontiers of
technology, the growth gains will diminish.
Average Years of Education of those aged > 15 in 1960 and 2000.
Country 1960 2000 Country 1960 2000
Australia 9.73 10.92 Japan 7.78 9.47
Austria 7.33 8.35 Netherlands 5.27 9.35
Belgium 7.67 9.34 N. Zealand 9.7 11.74
Canada 9.11 11.62 Norway 5.92 11.85
Denmark 9.05 9.66 Portugal 1.86 5.87
Finland 5.4 9.99 Spain 3.67 7.28
France 5.4 7.86 Sweden 8.07 11.41
Germany 8.18 10.2 Switzerland 7.39 10.48
Greece 4.83 8.67 Turkey 1.92 5.29
Ireland 6.4 9.35 U K 7.85 9.42
Italy 4.7 7.18 U S 8.49 12.05

Source: http://web.worldbank.org/
Education has increased especially in those countries that started with very low levels of
education. This also can be seen as increasing g.
Institutional factors.
These are hard to measure. In part they are things that may make investment less
attractive or barriers to the formation of human capital. Or they might be inefficiently
organised industries, or the public sector lack of competition.
Some people argue that the UKs poor performance in the 1960s and 1970s (relative to
other European countries) was due to institutional inefficiencies. But note: a lot of this is
due to other countries slowing down as they converged on the richer countries

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Nevertheless, the UK improved (relatively) from the 1980s. Some observers associate
this with the Thatcher reforms that reduced inefficiency by:
The reform of industrial relations leading to more efficient working practices.

The privatisation of a large number of public enterprises.

Liberalisation of the free working of markets, introducing more competition.

Reducing marginal tax rates to improve work incentives.

Reducing unemployment benefit and social security benefits to reduce the
incentive to be unemployed.

But note: these would mainly move the economy close to the PPF rather than causing a
progressive increase in the underlying productive capacity. Such gains are once and for
all improvements and would not be expected to continue forever.