Arts and Science 2E03 Why Governments Stimulate Saving

In the third section of our course, we will focus on short-run deviations of the economys
total output (real GDP) from its long-run sustainable value. The motivation is that we
wish to understand the determinants of cyclical unemployment, and what are known as
business cycles. But in this section of the course focus on the long-run trend in living
standards. To highlight this issue, we abstract from the short-run deviations from trend,
and consider a longer term analysis in which it is reasonable to assume flexible wages
and prices. In such a world, there is no difference between actual and potential output.
We focus on the long-run determinants of per capita consumption.

All western governments try to stimulate saving. Some of the initiatives are: taxing
consumption instead of income (partially replacing the income tax revenue with the
GST), allowing lower taxes on capital-gain income, allowing RRSP purchases to be made
with before-tax dollars, permitting tax-free savings accounts, and keeping inflation low.
This reading outlines what is known as the Solow growth model which is the analytical
basis for all these policies. (It is the more rigorous version of closed-economy trickle-
down economics.

Let k and y stand for the capital/labour ratio and the output/labour ratio (k = K/L and y =
Y/L). The standard production function, y = f(k), is illustrated in Figure 1. The fact that
the slope of this function gets flatter at higher capital/labour ratios reflects the standard
property of diminishing returns. We wish to use this diagram to illustrate how the
nations capital/labour ratio is determined.

We know that the capital/labour ratio will be rising if the numerator is growing faster
than the denominator. Capital (the numerator) grows whenever the nation produces new
output that is not consumed (as long as these new additions to the capital stock exceed the
quantity of capital that has disappeared through depreciation). Let that depreciation rate
be . Labour productivity tends to grow over time, so it is convenient to measure labour
in terms of efficiency units. As a result, labour (the denominator of the capital/labour
ratio) grows whenever the population and/or labour productivity grow. Let the sum of
these two growth rates be n. All this means that to keep the capital/labour ratio constant
capital must grow at a rate equal to ( + n). Thus, for balanced growth, we require
K / K n.

For the economy to be in equilibrium, the actual growth rate of capital must equal this
required growth rate of capital. The actual change in capital is saving:

S sY K .

Dividing this relationship through by K, we realize that the actual growth in capital
equals sf(k)/k. Finally, by equating the actual and the required growth rates for capital, we
have:

sf ( k ) ( n )k .
Figure 1 illustrates this equilibrium at point A. This point is the intersection of the
required capital growth line (which is the ray through the original drawn with a slope of
( + n)) and the actual capital growth curve (which is the savings function the sf(k)
curve). The savings function is a re-drawing of the production function with the height at
every point equal to fraction s times the production functions height. At points to the
left of A, the height of the actual savings (= investment) curve is greater than the height
of the ray which shows how much investment is needed to keep k constant. Thus, k does
not stay constant it rises. Similarly, at points to the right of A, the height of the actual
investment curve is less than the height of the required-for-k-to-stay-constant line, so k
falls. This reasoning implies that the economy must converge to point A.

Is it desirable for us to be at point A? Not if our goal is to have the maximum possible
value for per-capita consumption. Since the height up to the production function is output
per head, since the height up to the straight-line ray is investment per head, and since
consumption equals output minus investment, consumption per head is given by the
vertical distance between the production function and the required investment ray. We
can see in the diagram that this distance is maximized when it equals distance BC. Thus,
the economy needs to be at point B, not point A. For the economy pictured in Figure 1,
then, the government should use provisions in the tax system to induce people to have a
higher savings propensity (denoted by s2 in the diagram).

Figure 1 The Solow Growth Model and the Golden Rule

y
f(k)
( +n)k
C

s2f(k)
B
s1f(k)
A

k
k1 k*

How do we know that it is appropriate to draw the diagram so that without the pro-
savings policies we are to the left of the best k value (denoted by k*)? We know that
this is appropriate if without the pro-savings policies the slope of the production
function (which is the marginal product of capital) exceeds the slope of the required
investment ray ( + n). We can check real-world values to assess this requirement. What
do business executives demand as a minimum rate of return on their marginal products?
A number in the 12% range is customary. How does this compare to the slope of the ray?
The annual depreciation rate is in the 4% range, and the productivity-growth and
population-growth rates are roughly 3% and 1%. Overall, since 12% exceeds 8%, this
analysis supports the governments initiatives.

Here is another way of appreciating that our economy currently has a capital/labour ratio
that is smaller than what is known as the golden rule value. Since we believe that firms
maximize profits, we have to believe that in long-run equilibrium they must be
equating the marginal product of capital to its rental cost, (r ) . Thus, the presumption
must be that (r ) must exceed (n ) , or that r must exceed n = K/K. As we have
noted when discussing benefit-cost analysis, applied economists always assume that r
exceeds n. Indeed, it must be the case if net profits, rK, and net investment, K, as we
find in every year for all countries. Thus, we are confident that all these economies are
under-capitalized. Thus, Figure 2 correctly shows the time path for per-capita
consumption following a pro-savings initiative.

So higher saving involves short-term pain during the time interval between points 1 and 2
in Figure 2, since without the policy per capita consumption would have been higher
(following along the lower dashed line). But after point 2 in time, there is long-term gain.
Old people are hurt by the pro-savings policy, since they could die within the 1-to-2 time
period. But the young, especially those who are not born until after point 2 in time, are
made better off. From the point of view of the elderly, higher saving is a policy of
following the golden rule doing unto others (the young) what the elderly would like
others to have done for them.

Figure 2 Per-Capita Consumption and a Pro-Savings Initiative

ln C

Time
1 2
What About Non-Renewable Resources?
The production function in the Solow model involves just labour and capital. What about
raw materials in particular natural resources that cannot be replaced? We consider this
extension of the model in the remainder of these notes.

It seems that every generation involves a group that - like Malthus - is very concerned
about our running out of something that is central and important for economic growth.
For Malthus, it was food. For the Club of Rome a group of scientists who wrote the
widely read short book entitled Limits to Growth in 1970 it was minerals and fossil
fuels. Today, this concern about many exhaustible resources remains, and added to it is
an even more fundamental set of worries about species extinction, and the breakdown of
the entire environmental and climatic patterns that have existed up to this point in time.
How has mainstream economic analysis reacted to these concerns?

The reaction to the Club of Rome was immediate and highly critical. Economists asked
why there is any interest in simulations of mineral and fuel usage in which it is assumed
that there will never be any change in prices or in the pattern of demand. Surely,
economists argued, as these items become more scarce, their prices will rise. And as
these prices rise, demand will fall and the supply of substitutes will rise, so voluntary
conservation will naturally occur. After all, rising prices are the market's signal of
increasing scarcity, and so the market system has a self-correction mechanism rising
prices automatically leading to a reduced rate of resource use. By assuming no such price
increases would ever occur, the Club of Rome study was biased in the direction of
reaching it's alarmist conclusion (just like Malthus at least for developed economies).

Harold Hotelling wrote an important paper in 1931 that described this self-correction
feature concerning exhaustible resource prices for the first time, and in a more precise
fashion. To appreciate his argument, consider an owner of such a resource. She has two
options: sell a unit of the resource today and receive today's price p1 , or sell that unit
next period and receive tomorrow's price. This second option has a present value equal to
p 2 /(1 r ) . (r denotes the interest rate and we simplify by ignoring taxes.) In equilibrium,
resource owners must be indifferent between these two options, so these returns must be
equal. Simple manipulation of this equilibrium condition yields: p / p r . Thus, if the
supply of the resource truly is limited, we can expect that its price must rise at an
exponential rate equal to the interest rate. This implies that the price will rise to infinity in
finite time, and this development will provide a big incentive for individuals to look for
substitutes on the demand side, and to invest in inventing substitutes on the supply side.
Synthetic-rubber tires, plastics and light-metal alloys are all examples of such substitutes.

Let us consider this issue more formally. Assume that firms have the following
production function:

Y K E 1 ( AR )
Y, K E, R and A denote output, the capital (both physical and human) input, the energy
input, the remaining stock of the raw material, and the level of technical knowledge. The
exponents (the Greek letters) are positive fractions (and this imposes positive but
diminishing marginal products). This functional form for the input-output function is the
simplest that fits the data well. For simplicity, we lump labour and capital into one input,
so that we can concentrate on the trade-off between reproducible inputs (capital) and non-
reproducible inputs (with the example being energy here.) As in the Solow model, A is
assumed to grow at a constant exogenously determined rate. As noted above, R is the
remaining stock of energy at each point in time. As this stock dwindles, producers are
forced to use ever more expensive sources of energy, so for any given level of the other
resources employed, firms get less output. (This feature is imposed by parameter being
positive, and it is referred to as the "depletion effect" in the literature.)

There is a definitional relationship between the remaining stock of the resource and the
amount used each period. This relationship simply states that this period's use, E, equals
this period's reduction in the remaining stock: R E . But there is an externality effect
present, since each individual firm regards itself as being too small for its energy use to
have any appreciable effect on the nation's remaining stock of the resource. Thus, the
identity just given is ignored at the individual level as firms and households optimize.
This lack of taking account of the negative spillover effect on others is the initial
"second-best" problem that makes it possible for a government initiative that induces
individuals to utilize the resource at a slower rate to have a limited negative effect on
people's material living standards.

Let us assume a constant rate of utilizing the natural resource: u = E/R. Given the
R E identity, we know that u E / E R / R . We wish to focus on a balanced
growth equilibrium where the growth in all major aggregates is the same. Let that growth
rate be n C / C Y / Y K / K . We wish to investigate how a reduction in the
resource utilization rate, u, affects this growth rate in material living standards, n. We will
now see that if the government imposes this pro-environment policy, the rate of growth
of material living standards would increase not decrease as it seems to be assumed in
public debate of this issue. The expression for the equilibrium growth rate can be derived
by taking logs, and then first differences, of the production function given above. First,
we divide both sides by Y : Y 1 ( K / Y ) E 1 AR

After taking logs and then first differences, and then substituting in A / A ,
E / E R / R u , and K / K Y / Y n , we have

n ( (1 )u ) /(1 ).

This result implies two important things. First, as long as the rate of technological
advance, , is big enough, it is possible to have ever-rising living standards even though
the exhaustible resource is inexorably vanishing. This possibility exists since increased
technical knowledge can be rapid enough to allow us to shift away-from resource-
intensive production to capital-intensive production, and capital is man-made. Empirical
studies have suggested that is big enough for n to be solidly positive. However, it must
be admitted that the analysis has "stacked the cards" in favour of reaching this optimistic
conclusion since the particular input-output function that has been assumed involves an
elasticity of factor substitution of unity (a value that may be implausibly high). Quite
simply, it may not be possible for us to substitute capital for the natural resource and still
be able to produce the final good (as readily as this particular production function
assumes).

The second implication of the last equation is that the equilibrium growth rate in material
living standards increases when a lower resource utilization rate is imposed. This
government policy forces private agents to keep a bigger stock of the resource all along
the growth path. As a result, each unit of capital has a higher marginal product. This
outcome increases the yield on capital (the interest rate) and so it increases the return on
saving. Individuals react by saving more, so the economy has more capital all along the
balanced growth path. This is how living standards are higher despite society using less
of the resource.

There will, of course, be some short-term pain incurred as this long-term gain is
achieved, since (as with all pro-savings initiatives) increased capital formation means less
consumption for a while. Nevertheless, it seems that there may be tension involved in
our governments views on tax policy and natural-resource policy. To be in favour of
standard tax reforms, our policy makers must have come to the judgment that the long-
term gain dominates the short-term pain. The results concerning non-renewable resources
and material living standards reported here suggest that if there is a desire for internal
consistency our government may be forced to focus on the long-term gain when
devising natural-resource policy as well. If the short-term pain is worth it in tax policy,
why isnt it similarly worth it in environmental policy? We should not push this line of
argument too far, since numerical simulations indicate that the short-term pain lasts
longer in the environmental policy case. Nevertheless, the analysis indicates that
mainstream economics supports green initiatives much more than our disciplines
critics (such as David Suzuki) acknowledge.

Returning to a focus on the longer run (the balanced-growth path), this analysis is an
example of the "win-win" possibility that can emerge when market failure occurs initially
(when the pre-policy situation is second best). When the government addresses the
externality problem, we can win on both the environmental front and on the material
living standards front.