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Macroeconomics Mankiw 8th Edition Solutions Manual

C H A P T E R 9
E c o n o m i c G r o w t h I I : Te c h n o l o g y ,
Empirics, and Policy
Notes to the Instructor
Chapter Summary
This chapter continues the presentation of the Solow growth model started in Chapter 8. The
chapter begins by adding labor-augmenting technological progress to the model. This
addition completes the Solow growth model. Once the complete model is developed, it is used
to address how public policy affects growth and development. The last section of the chapter
examines some of the weaknesses of the Solow growth model and introduces the student to
endogenous growth theory. In addition, there is an appendix on growth accounting based on
the Solow growth model.
Building on the lessons of Chapter 8, the three sections of this chapter teach the
following lessons:
1. Technological progress is the sole determinant of growth in living standards in the
long run.
2. Policymakers would like to raise saving and technological progress, but these goals are
not easy to achieve. In addition, the productivity slowdown of the past two decades
presents one of the most important and perplexing problems currently facing
economists and policymakers.
3. A weakness of the Solow growth model is its failure to explain what drives tech-
nological progress. Endogenous growth theory attempts to incorporate the source of
technological progress into a growth model.

Comments
This chapter expands the Solow growth model of Chapter 8 to explain sustained growth in
output per capita and thus the ongoing rise in the standard of living. The chapter also
discusses endogenous growth models that, unlike the Solow model, allow for endogenous
technological progress. Supplement 9-9 continues the informal presentation of the model
started in Supplement 8-9.
As noted in the comments on Chapter 8, the material on economic growth is one of the
more difficult topics covered in the textbook. The following is a list of common difficulties
encountered with the Solow growth material presented in this chapter and ways to overcome
them.

1. The Meaning of Effective Worker

The analysis of population growth often seems easy to students while that of technological
progress seems difficult. Since they are analytically identical, the main problem apparently
comes in understanding what we mean by effective worker. Supplement 3-2, which discusses
human capital, may be helpful; see also the intuitive presentation in Supplement 9-9.

2. Why Does Technological Progress Reduce k?

Students find it counterintuitive that technological progress reduces the capital–labor ratio,
probably because of the difficulty of interpreting the concept of effective worker. To
emphasize that, the lower k does not mean that technological progress is bad; one can
explain the thought experiment of introducing technological progress into an economy
originally in steady state with g = 0. The most important observation is that output, and

215
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216 CHAPTER 9 Economic Growth II

hence living standards, starts to improve immediately. The capital stock increases as output
increases, but initially at a slower rate than the rate of technological progress, so capital per
effective worker declines.
3. Confusion Among a Number of Similar Graphs and Variants of
the Model
The following are suggestions to correct such confusion:
(a) Make some or all of the discussion intuitive rather than mathematical; see
Supplements 8-9 and 9-9.
(b) Stress that there is ultimately just one model with a number of special cases.
The entire Solow model can be reduced to a single graph showing f(k), sf(k), and
(n + δ + g)k; if students understand this, they understand the model. The
summary table in the Lecture Notes for Section 8-1 may also help.
(c) When presenting the two-sector endogenous growth model, explain how this
works like the Solow growth model if u is held constant, where s determines the
steady-state capital stock and u determines the growth of knowledge.

4. Difficulties Relating the Model to the Real World

The Solow model can be roughly calibrated to the U.S. economy. If the population L = 280
million, Y = $10 trillion, and K = $25 trillion (see Chapter 9 in the textbook), then
(measuring in $1000) k = 89.3 and y = 35.7. This implies that the production function, with
capital’s share equal to 30 percent, is given as:
Y = Ak0.3, where A = 9.3.
If δ = 0.04 and n + g = 0.03, then (n + g + δ)k = 6.3 (again, see Chapter 9 in the textbook). To
determine the saving rate that ensures the economy is at a steady state, set sf(k) = 6.3 and
solve for s. The economy will be in a steady state when s = 0.175. This calibration could be
used to study the decline in saving in the United States during the 1980s and early 1990s,
the slowdown in growth following the oil shocks of the early 1970s, and the recent pickup in
growth during the last half of the 1990s. The Web-based Macroeconomics Models may also
be useful for such analysis.

Use of the Dismal Scientist Web Site

Go to the Dismal Scientist Web site and download data for total business fixed investment
and investment in information technology and software over the past 40 years. Compute the
ratio of investment in information technology and software to total business fixed
investment. How has this ratio changed over time? Discuss whether the data are consistent
with the pickup in trend productivity growth during the late 1990s.

Chapter Supplements
This chapter contains the following supplements:
9-1 More on the Convergence Hypothesis
9-2 Convergence of Income Across the United States
9-3 More on the Productivity Slowdown (Case Study)
9-4 More on the New Economy (Case Study)
9-5 The Economics of Ideas
9-6 Green Growth
9-7 Corruption and Growth
9-8 Income Inequality and Growth
9-9 The Solow Growth Model: An Intuitive Approach—Part Two
9-10 Additional Readings
 Lecture Notes 217

Lecture Notes

Introduction
The Solow growth model as developed in Chapter 8 showed how changes in the
capital stock and population growth affect the long-run level of output of the
economy. This chapter adds changes in technology to complete the model. The
complete Solow growth model can then be used to examine how public policies
influence saving and investment and thus affect long-run economic growth.
While the Solow model is a useful tool for understanding economic growth, it
is not without its weaknesses. Macroeconomists have attempted to address some of
these weaknesses to better understand the process of economic growth.

9-1 Technological Progress in the Solow Model

Chapter 8 provided an explanation of persistently rising output, but we have not
yet explained rising living standards. To do so, we incorporate technological
progress, meaning that we are able to produce more output with a given amount of
capital and labor.

The Efficiency of Labor

Technological progress is a slightly trickier process to incorporate into the model.
The reason is that it can enter the production function in different ways; it may
increase the productivity of capital or labor. The simplest form to analyze is labor-
augmenting technological progress. Return to the production function and amend it
so that
Y = F(K, L × E).
Here, E measures the efficiency of labor. The bigger E is, the more output can be
produced with a given amount of labor. We suppose that technological progress
comes about from increases in the efficiency of labor over time.
This assumption makes analysis simple since increases in the productivity of
labor now look just like increases in population. If either L or E increases, output is
affected in just the same way. For this reason we call L × E the number of effective
workers. In other words, labor-augmenting technological progress works as if we
are getting more workers. If we have progress at the rate g = 0.02, then 100
workers can produce this year what it would have taken 102 workers to produce
last year. If L grows at the rate n and E grows at the rate g, then L × E grows at the
rate n + g.

The Steady State With Technological Progress

Now redefine k to be capital per effective worker (k = K/LE), and likewise, y =
Y/LE. The analysis of technological progress is now exactly analogous to that of
➤ Figure 9-1 population growth. The economy will be in steady state with k constant when
∆k = sf(k) – (n + δ + g)k = 0
or
sf(k) = (n + g + δ) k.

The Effects of Technological Progress

In steady state, output, capital, and consumption per worker are all growing at the
rate g. The model can now explain rising living standards. According to the Solow
➤ Table 9-1 model, technological progress is the only source of rising living standards over time.
218 CHAPTER 9 Economic Growth II

The analysis of the Golden Rule is again altered when we have technological
progress. The condition for maximum consumption per effective worker is
MPK – δ = n + g.
To summarize:
Population Population Population Growth = n;
Growth = 0 Growth = n Technological Progress = g

L is constant L grows at rate n L grows at rate n

K is constant
k = K/L is constant
Y is constant
y = Y/L is constant
LE grows at rate n + g
K grows at rate n K grows at rate n + g
k = K/L is constant k = K/(LE) is constant
K/L grows at rate g
Y grows at rate n Y grows at rate n + g
y = Y/L is constant y = Y/(LE) is constant
Y/L grows at rate g

9-2 From Growth Theory to Growth Empirics

Thus far, we have used the Solow model to help us understand how policy might
influence economic growth. We now turn to the question of how well the model fits
the empirical facts.

Balanced Growth
Data for the United States bear out the predictions of the Solow model for
technological progress reasonably well. As predicted by the model, output per
worker-hour and capital per worker-hour have tended to grow at roughly the same
rate (2 percent). Also, as the Solow model predicts (see end-of-chapter Problem 3),
the real wage has tended to grow at this rate, while the real rental price of capital
has stayed approximately constant.

Convergence
The differences in living standards around the world are staggering. Yet the Solow
model suggests that economies are likely to converge toward the same steady
state—at least if they possess similar technologies and have similar rates of saving
and population growth. If the differences between rich and poor countries are just
due to the fact that rich countries have more capital, then we would expect poor
countries to accumulate capital faster, and so eventually catch up with richer ones.
Although the Solow model predicts convergence, other theories of growth
➤ Supplement 9-1, (see Section 8-4 on endogenous growth theories) suggest that there are circum-
“More on the stances under which convergence will not occur. Economists are not fully agreed
Convergence on whether or not countries are in fact converging to similar standards of living.
Hypothesis” But the data provide some support for the view that—once we take account of
➤ Supplement 9-2, differences in saving rates, population growth, and education—countries are con-
“Convergence of verging. In other words, countries exhibit conditional convergence, reflecting
Income Across the movement toward individual steady states that depend on saving rates,
United States” population growth, and education.

Factor Accumulation Versus Production Efficiency

Cross-country differences in income per person arise either because of differences in
capital per person (physical capital and human capital) or because of differences in
 Lecture Notes 219

the efficiency with which factors are employed. Although results vary from study to
study, research has shown that both factor accumulation and productive efficiency
are important in determining differences in income per person. Deciding which is
more important, however, is difficult, because countries that have highly efficient
economies tend also to accumulate a lot of capital (and vice versa), blurring cause
and effect.
Furthermore, it is possible that both factor accumulation and productive
efficiency are determined by a common factor, perhaps the quality of a nation’s
legal and political institutions. So countries with “good” institutions are also ones
that experience greater factor accumulation and/or more rapid gains in productive
efficiency.

Case Study: Is Free Trade Good for Economic Growth?

As Adam Smith noted, international trade allows countries to specialize in
productive activities in which they have a comparative advantage. So one might
expect that countries that are open to trade would have higher living standards
than countries that are closed to trade. The empirical evidence shows that countries
that are more open to trade indeed do experience more rapid economic growth than
those that are closed to trade. In addition, the evidence shows that after countries
open up to trade, they typically grow more rapidly than before. But these
correlations between openness and growth do not necessarily imply causation, since
it may be the case that countries with open-trade policies tend also to have other
economic policies and institutions that encourage growth. One way to sort out
whether trade causes growth is to find variables that are correlated with trade but
are not correlated with other policy or institutional variables. In a recent paper,
Jeffrey Frankel and David Romer note that geographical distance from other
trading partners and whether a country is landlocked are important determinants
of how much a country trades (i.e., its “openness”), but are unlikely to be correlated
with other policy variables. They then use this insight in applying instrumental
variable techniques to the data and find that increased trade leads to higher GDP
per person.

9-3 Policies to Promote Growth

What are the policy implications of the Solow growth model?

Evaluating the Rate of Saving

A natural starting point for evaluating the saving rate is to see if the U.S. economy
is above the Golden Rule, since we know that policymakers could then make
everybody better off by discouraging saving. We need to compare the growth rate
(n + g) with the return to capital net of depreciation (MPK – δ).
The following are true for the U.S. economy:
1. K ≅ (2.5)Y.
2. ∆K ≅ (0.1)Y.
3. Capital’s share of output ≅ 0.3.
From (1) and (2), we can calculate δ = 0.04. Recall also that capital’s share of
output = (MPK × K/Y) if factors are paid their marginal product. We know from
(1) that K/Y = 2.5, so we can infer from (1) and (3) that MPK ≅ 0.12. So MPK – δ
= 0.08. The growth rate for the U.S. economy, however, is about 3 percent per
year. Thus, the marginal product of capital net of depreciation exceeds the
growth rate, indicating that the capital–labor ratio is considerably below the
Golden Rule. Increasing the saving rate would permit higher consumption in the
long run (though, as we noted before, at the cost of decreased consumption in the
present).
220 CHAPTER 9 Economic Growth II

Changing the Rate of Saving

Although the Solow model as set out here excluded the government for simplicity, we
know from the analysis of the classical model that national saving depends on both
private saving and government saving. One way, therefore, for policymakers to change
the saving rate is by increasing public saving—running government surpluses rather
than government deficits. Recall from the analysis of the classical model that
decreases in public saving lead to crowding out of investment. The long-run
consequence of this, as the Solow growth model shows, is a lower capital stock.
Policymakers can also enact policies to affect private saving decisions. Tax exemptions
for Individual Retirement Accounts (IRAs) are an example of a measure designed to
encourage private saving. Economists remain divided over the effectiveness of policies
to promote increases in private saving.

Allocating the Economy’s Investment

Although the Solow model assumes a single capital good, it is helpful to distinguish
three different types of capital. First, there is private physical capital: the factories,
➤ Supplement 3-2,
machinery, and the like used by firms to produce goods. Second, there is public
physical capital—that is, capital goods that are provided by the government, such as
“What Is Capital?”
the interstate highway system. Such goods are often known as infrastructure. And
third, there is human capital, or the knowledge and skills of people in the economy.
Recent work on economic growth has focused much attention on the role of
infrastructure and human capital. Most economists now agree that accumulation of
human capital is as important a contributor to economic growth as physical capital,
and some argue that the government should encourage investment in human capital.
Some economists also argue that increased investment in infrastructure is desirable.

Case Study: Industrial Policy in Practice

A long-standing debate in economics revolves around whether governments should
promote certain industries or firms because of their importance to the economy.
This debate in the United States goes back to the early days of the country and the
Tariff of 1789, which was intended to help develop domestic manufacturing. One
example often pointed to by supporters of industrial policy is the success of the
Internet—a government-sponsored defense project that, by all estimation, has had
large effects on productivity. But critics point to other instances where government
intervention hindered advances or subsidized ventures that ultimately proved
unsuccessful. Even Japan’s Ministry of International Trade and Industry (MITI),
often looked at as a successful architect of industrial policy, initially opposed
Honda’s expansion from producing motorcycles to producing automobiles. The
company moved ahead anyway and became one of the most successful auto
producers in the world—although probably later than it otherwise would have.

Establishing the Right Institutions

As noted earlier, nations have differences in per-capita income because of
differences in factor accumulation and differences in production efficiency. In turn,
nations may have different levels of production efficiency because they have
different political and legal institutions that affect the allocation of scarce
resources. For example, the extent of legal protection afforded shareholders and
creditors may influence the functioning of capital markets and thus the allocation
of capital in the economy. More generally, the “quality” of the government may play
an important role in protecting property rights, enforcing contracts, preventing
fraud, spurring competition, etc., helping ensure greater market efficiency. In
nations where expropriation, bribery, payoffs, etc., are the norm, resources that
could increase per capita income are siphoned off to the benefit the powerful at the
expense of society. The evidence suggests that the level of corruption in a nation is
inversely related to its rate of economic growth.
 Lecture Notes 221

Case Study: The Colonial Origins of Modern Institutions

A nation’s geographical latitude is strongly correlated with its income per capita.
Nations located near the equator typically have a lower income per capita than nations
farther away from the equator. This finding holds for both the northern and southern
hemispheres. Some economists argue that this correlation is due to the direct effect of
tropical climates on productivity in agriculture and industry—hot climates are
associated with more disease and generally poorer results in agriculture. Recent work
by Daron Acemoglu, Simon Johnson, and James Robinson goes beyond the direct effect
of climate on productivity to consider the indirect effect of climate on institutions.
These authors argue that the presence of tropical disease dissuaded Europeans from
settling in tropical areas and opting instead to establish permanent settlements in
more temperate climates, e.g., the American colonies, Canada, and New Zealand. In
regions where Europeans established permanent settlements, they also brought with
them the political and legal institutions of their homelands, which protected property
rights and limited the power of government. But where they colonized and did not
settle, the Europeans set up extractive institutions, such as authoritarian governments
that were designed to exploit natural resources for export. These institutions made the
colonizers rich but did not do much to promote economic growth. Over the centuries, as
colonialism faded, the institutions that emerged were similar in structure to those that
were originally put in place during the colonial era. The legacy continues today:
Tropical nations are more likely to have authoritarian governments run by modern
elites than representative governments with strong legal institutions. To the extent
that institutional quality helps determine economic success, tropical-latitude nations
with lower quality institutions (corrupt governments, weaker enforcement of property
rights, etc.) will be less prosperous than temperate-latitude nations.

Encouraging Technological Progress

Having gone through the Solow model in some detail, we are left with a somewhat
disturbing conclusion from the point of view of our theory. Explaining growing
living standards means explaining technological progress, which is exogenous in
the model. Economists do not yet have a very good understanding of the sources of
technological progress. Nonetheless, government policies are often directed to
encouraging technological progress. Such policies include tax breaks for research
and development and government funding of basic research. More broadly,
government subsidization of education, by improving the skills of the work force,
may increase the efficiency of labor.

Case Study: The Worldwide Slowdown in Economic Growth

Economic growth slowed sharply after the early 1970s. This slowdown was worldwide
➤ Table 9-2 and has been attributed to a decline in the rate of technological progress. The
downshift in growth meant that living standards for many countries rose more slowly
➤ Supplement 9-3, in the 1970s and 1980s than they had in the 1950s and 1960s. Macroeconomists have
“More on the sought to understand the reasons for this slowdown because even small declines in
Productivity growth rates compound rapidly to have large effects on income and living standards.
Slowdown” Some explanations of the productivity slowdown include:
1. an increase in the difficulty in measuring productivity as a result of an
increase in service-sector employment and unmeasured quality improvements;
2. faster obsolescence of capital in the 1970s due to the large changes in oil prices;
3. a decrease in overall skills due to demographic change (i.e., the entrance of the
baby-boom generation into the labor force); and
4. a decline in inventiveness.
The worldwide slowdown in growth that began in the early 1970s seems to have
ended sometime in the mid-1990s. In the United States, GDP per person has grown
222 CHAPTER 9 Economic Growth II

➤ Supplement 9-4, by 2.0 percent per year since 1995, compared with just 1.5 percent per year from
“More on the New 1972 to 1995. This increase in the growth rate has been described by some
Economy” observers as the dawning of a “New Economy.”
Economists are not completely certain as to why growth suddenly surged in
the 1990s, but many suspect that it had something to do with advances in
computing and other information technologies. Although mainframe computers had
been around since the 1950s and 1960s, and personal computers became a common
business tool in the 1980s, productivity growth did not pick up until the mid-1990s.
One reason for this delay is that the computer sector, although growing very
rapidly, remained negligible compared to the overall economy until the late 1990s.
Another reason is that effective use of computers and other information
technologies often requires reorganization of the work place and retraining of
workers—something that takes time to accomplish.
This episode of rapid growth came to a halt with the severe recession of
2008–2009 and sluggish recovery in the years since. As a result, average growth
from 1995 to 2010 now shows no pickup from the period prior to the mid-1990s.

9-4 Beyond the Solow Model: Endogenous Growth Theory

How to incorporate the process of technological change into a growth model?

The Basic Model

Start with a production function
➤ Supplement 9-5, Y= AK,
“The Economics of
where A is a constant measuring the amount of output produced for each unit of
Ideas”
capital. This is known as an AK model. The production function does not exhibit
➤ Supplement 9-6,
diminishing returns to capital.
“Green Growth”
If s is the fraction of income saved, then
➤ Supplement 9-7,
“Corruption and ∆K = sY – δ K,
Growth”
which together with the production function implies
➤ Supplement 9-8,
“Income Inequality ∆Y ∆ K
= = sA – δ.
and Growth” Y K

Thus, as long as sA > δ, the economy grows forever. Note that this does not require
the assumption of exogenous technological progress.
Does it make sense that capital does not exhibit diminishing returns? No, if
capital is defined as the stock of plants and equipment. Yes, if capital is broadly
interpreted to include the stock of knowledge. Some economists argue that there
are increasing returns to knowledge.

A Two-Sector Model
The AK model developed above is the simplest example of an endogenous growth
model. A more sophisticated version incorporates two sectors: a manufacturing
sector that produces goods and services for either consumption or investment in
physical capital K and a research sector comprised of universities that produce
knowledge, E, which is used in both sectors.
The economy can be described by three equations:
1. Y = F[K, (1 – u)EL] the production function of manufacturing firms
2. ∆E = g(u)E the production function for research
3. ∆K = sY – δK capital accumulation.
The fraction of the labor force working in research is u. The stock of knowledge, E,
 Lecture Notes 223

determines the efficiency of labor. Both the manufacturing and the research sectors
exhibit constant returns to scale.
This model is similar to the basic AK model in that capital exhibits constant
returns to scale since capital includes both physical capital and human capital
(knowledge). The model is also similar to the Solow growth model. For any given u,
the following hold:
• s determines the steady-state stock of physical capital,
• u determines the growth in the stock of knowledge,
• s and u determine the level of income, and
• u determines the steady-state growth rate of income.

The Microeconomics of Research and Development

There are three microeconomic facts of research and development:
1. Much research is done by firms that are driven by profit motives.
2. Research is profitable because innovations give firms temporary monopoly
power.
3. Firms build on the innovations of other firms.
Some endogenous growth models have attempted to incorporate these microeconomic
facts of research and development (R&D) to offer a more complete description of
technological innovation. One question such models are used to address is whether
firms engage in the socially optimal amount of R&D. That is, does the benefit of R&D
to society (social return) equal the benefit to the firm (private return)? Empirical
studies indicate that firms undertake too little R&D (social benefit > private return).
This has led some economists to argue for government subsidies for R&D.

The Process of Creative Destruction

Economist Joseph Schumpeter proposed that economic growth occurs through a
process known as “creative destruction.” His theory viewed new firms as continually
entering the marketplace, having monopoly power over their innovations, and reaping
the profits that induced the firms to enter the market in the first place. Consumers
benefit from the greater choice of products, but existing firms now face competition.
Some of these established firms cannot compete and go out of business. This process
continues over time, with new firms entering and established firms exiting—a process
of “creative destruction.” Historical evidence appears to confirm Schumpeter’s theory.
For example, in nineteenth-century Britain, automated looms operated by low-skilled
workers replaced hand weaving by highly skilled artisans. The new machines were far
more productive and displaced the earlier technology. More recently, the emergence of
Walmart as the preeminent retailer illustrates how innovations in marketing,
inventory control, and personnel management have made it difficult for small retail
stores to compete. At the same time, however, consumers have reaped the benefits of
lower prices and greater variety that Walmart provides.

9-5 Conclusion
While the Solow model explains the long-run determination of the capital stock and
teaches us where to focus our attention, if we want to explain economic growth, it is
unsatisfactory in that it takes as exogenous precisely those variables identified as
sources of growth—population change and technological progress. It also takes as
exogenous the saving rate, which is the key determinant of the capital–labor ratio.
More advanced work in economics attempts to endogenize these variables. Not
surprisingly, recent approaches to economic growth have paid particular attention
to explaining technological progress.
224 CHAPTER 9 Economic Growth II

Appendix: Accounting for the Sources of Economic Growth

Growth accounting attempts to decompose overall output growth into its
constituent sources: changes in labor, capital, and technology.

Increases in the Factors of Production

First, we hold the technology constant. Recall the following definitions from
Chapter 3:
MPK = F(K + 1, L) – F(K, L);
MPL = F(K, L + 1) – F(K, L).
Given a change in capital ∆K and a change in labor ∆L, we then have
∆Y = (MPK × ∆K) + (MPL × ∆L).
Now divide through by Y to get

= α(∆K/K) + (1 – α)(∆L/L),
where α is capital’s share of output if factors are paid their marginal product (MPK
× K is just total payments to capital, and likewise for labor).
Everything in this equation is measurable. We have data on capital’s share of
output (α) and on the growth rates of output, capital, and labor. For U.S. data, this
equation does not hold. Between 1950 and 1999, output grew at an average rate of
3.6 percent per year, but growth in capital and labor together accounted for only 2.5
percentage points of this output growth per year. The explanation for this discrep-
ancy is that we have not yet considered the contribution from technological
progress. We can conclude that the remaining 1.1 percentage points of output
growth per year must be accounted for by improvements in technology since it
cannot be explained by changes in factors of production.

Technological Progress
To include technological progress, write the production function as
Y = A × F(K, L),
where A is a measure of total factor productivity. Then, the growth accounting
equation is amended to read

= α(∆K/K) + (1 – α)(∆L/L) + ∆A/A.

The term ∆A/A measures any change in output that cannot be accounted for by
changes in inputs. It is called the Solow residual, after the Nobel Prize-winning
economist Bob Solow.

The Sources of Growth in the United States

➤ Table 9-3 Table 9-3 presents decade-by-decade decompositions of U.S. economic growth into
its constituent sources.

Case Study: Growth in the East Asian Tigers

Many businesspeople, economists, and other commentators have noted the
phenomenal economic success of certain countries in East Asia—particularly Hong
Kong, Singapore, South Korea, and Taiwan. Real per-capita GDP grew by about 7
percent per year on average in these countries between the mid-1960s and the early
1990s. Recent research suggests that their success can largely be explained by
 Chapter Supplements 225

growth in labor, capital, and human capital, rather than more rapid growth in total
factor productivity.

The Solow Residual in the Short Run

This appendix shows how we may infer the effect of technological change on the
➤ Figure 9-2 economy by using the techniques of growth accounting. Any variation in output
that cannot be explained by changes in capital or labor, so the reasoning goes, must
be the result of technological progress. This unexplained change in output is known
as the Solow residual. The Solow residual has, in fact, fluctuated substantially in
the past. It rises during expansions and falls during recessions. Economist Edward
Prescott has argued that such fluctuations in technology are an important source of
short-run changes in economic activity. The Solow residual is, however, an
imperfect measure of technological progress in the short run.
One reason for this is that firms and workers are usually engaged in a long-
term relationship, so firms do not necessarily hire and fire workers with every
temporary change in their productivity. In a recession, firms engage in labor
hoarding—that is, they keep workers on the payroll in order to have them on hand
when the recession is over. Labor hoarding implies that the technology varies less
than is suggested by the measured Solow residual.
A second reason why the Solow residual is an imperfect measure of
technological progress is that, during recessions, output probably is higher than the
level measured by official GDP. Firms often have workers perform tasks such as
cleaning the factory and organizing inventory during times when business has
slowed, but this activity is not generally accounted for in the National Income
Accounts’ measures of output. As a result, output and the Solow residual appear
lower than they actually are during recessions. The evidence on labor hoarding and
cyclical mismeasurement of output, however, is not clear-cut, and so the debate
goes on between proponents and critics of real business cycle theory.
 ADDITIONAL CASE STUDY

9-1 More on the Convergence Hypothesis

The Solow growth model suggests that economies with similar rates of population growth
and technological progress should exhibit similar levels of per-capita income in the long run,
regardless of their initial capital stock. During the adjustment to steady state, countries
with a lower capital stock will grow faster than those with higher capital stocks. This is
known as the convergence hypothesis. Some recent theories of endogenous growth, by
contrast, do not imply convergence. Rather, they suggest that there may be constant or
increasing returns to capital and, hence, no tendency for convergence in per-capita income.
There is as yet no consensus on whether or not countries do exhibit convergence in per-
capita income. Figure 1 shows a scatterplot of growth rates since 1960 against output per
worker in 1960. The simple convergence hypothesis suggests that these variables should be
negatively related: Countries with higher GDP per person should grow more slowly. Such a
relationship is not apparent in Figure 1, casting doubt on the convergence hypothesis.
Results on convergence depend in part on the sample of countries examined: There is much
stronger evidence of convergence among those countries that are already relatively affluent
(as can be seen by looking at the right half of Figure 1), and economists who have looked at
this sample have generally concluded in favor of convergence.
Greg Mankiw, David Romer, and David Weil point out that the Solow model does not
literally imply that all countries should converge to the same steady state, however, because
of differences in saving rates and population growth rates. After correcting for these
differences and also for differences in human capital, Mankiw, Romer, and Weil find that
there is much stronger evidence of convergence, as can be seen from Figure 2.1

Figure 1 Figure 2
7 7
6 6
Growth rate: 1960–1985
Growth rate: 1960–1985

5 5
4 4
3 3
2 2
1 1
0 0
–1 –1
–2 –2
5.5 6.5 7.5 8.5 9.5 5.5 6.5 7.5 8.5 9.5
Log output per working-age adult: 1960 Log output per working-age adult: 1960

Source: Figures 1 and 2: G. Mankiw, D. Romer, and D. Weil, “A Contribution to the Empirics of Economic Growth,” Quarterly Journal of Economics
107, no. 2 (May 1992): 407–38.

1
G. Mankiw, D. Romer, and D. Weil, “A Contribution to the Empirics of Economic Growth,” Quarterly Journal of Economics 107, no. 2 (May 1992):
407–38. Mankiw, Romer, and Weil suggest that a production function such as Y = (K × L × H)1/3, where H is human capital, might describe the U.S.
economy. This can be rewritten as Y = K1/3(E × L)2/3, where E measures the efficiency of labor and E = (H/L)1/2.

226
ADDITIONAL CASE STUDY

9-2 Convergence of Income Across the United States

The Solow growth model predicts that economies with similar rates of saving, population
growth, and technological progress should converge over time. Poor economies should catch
up to rich economies and eventually have similar levels of per-capita income. As Figure 1
shows, regional differences in per-capita personal income across the United States have
narrowed considerably since the Great Depression. In 1929, the Mideast was the richest
region, with income nearly 40 percent above the national average, while the Southeast was
the poorest region, with income just above 50 percent of the national average. By 2004, the
gap between the richest and poorest regions had narrowed considerably, with New England
in the top position at a little over 20 percent above the national average and the Southeast
and Southwest tied in the bottom slot at 90 percent of the national average.

Figure 1 Per Capita Personal Income as a Percentage of U.S. Average By Region, 1929–2010
160
Mideast Far West

140
New England
Great
120
Lakes

100 Plains Rocky Mt.

80
Southwest

Southeast
60

40
9

34

49

59

64

69

79

89

99

09
2

0
19

19

19

19

19

19

19

19

19

19

19

19

19

19

19

20

20
Source: U.S. Department of Commerce, Bureau of Economic Analysis.

227
CASE STUDY EXTENSION

9-3 More on the Productivity Slowdown

Table 9-2 of the textbook shows evidence of a worldwide slowdown in economic growth
starting in the early 1970s. This slowdown was attributable in turn to a decline in
productivity growth. Concern about this productivity slowdown, however, may have been
premature, as growth appears to have picked up again in the 1990s (see Supplement 9-4).
Still, economists’ concerns are understandable since small changes in growth rates
accumulate over time into large changes in living standards.
One reason that growth after the early 1970s looked so bad is that growth the 1950s
and 1960s was high by historical standards. The decline in productivity growth may have
simply reflected a return to the slower, more “normal” pace of the late nineteenth and early
twentieth centuries.1 Other explanations for the productivity slowdown also have been
proposed.
Michael Darby argues that the apparent slowdown may simply be a result of measure-
ment problems. The U.S. economy is moving toward services and high-tech industry. Pro-
ductivity is hard to measure in the service sector, and quality changes may go unmeasured
in the high-tech and service sectors. The resulting measurement bias may have caused
growth rates to be understated by more than half a percentage point since 1979.2
The United States has also been experiencing a relative productivity decline. Between
1870 and 1930, U.S. productivity growth exceeded the average growth of 16 (relatively
affluent) countries analyzed by William Baumol, Sue Anne Batey Blackman, and Edward
Wolff; between 1950 and 1980, U.S. productivity growth was little more than half the
average of the same 16 countries.3 This is not necessarily bad for the United States since, if
other countries are more productive, we obtain cheaper imports, but it does have
implications for the relative standing of the United States as a world economic power.
Some economists have emphasized the role of human capital in explaining the
productivity slowdown. One possibility is that declines in educational quality, for whatever
reason, lie behind declining productivity. Another is that talent is misallocated. Kevin
Murphy, Andrei Shleifer, and Robert Vishny provide some evidence to suggest that growth
may be adversely affected if talented young people are attracted to careers that do not
directly create wealth. As they put it, “Lawyers are indeed bad, and engineers good, for
growth.”4 (The policy implication is given in Henry VI, Part 2, IV, ii, 73.)
The economist Paul Romer has advanced another theory of the productivity slowdown.
He argues that externalities associated with capital accumulation should lead us to revise
the traditional growth accounting. In particular, he claims that the percentage change in
output associated with a given percentage change in the capital stock is much larger than
capital’s share of output. According to Romer, the aggregate production function for the
α
United States would be better written as Y = K Lβ, where α has a value between 0.7 and 1.0,
and β has a value between 0.1 and 0.3. 5

1
See J. Williamson, “Productivity and American Leadership: A Review Article,” Journal of Economic Literature 20, no. 1 (March 1991): 51–68.
2
M. Darby, “Causes of Declining Growth,” Policies for Long-Run Economic Growth, Federal Reserve Bank of Kansas City (1992), 5–13.
3
Table 1 in J. Williamson, “Productivity and American Leadership: A Review Article,” Journal of Economic Literature, which is based on Table 5-1 in
W. Baumol, S. Blackman, and E. Wolff, Productivity and American Leadership: The Long View (Cambridge, Mass.: MIT Press, 1989). This observation
is consistent with the convergence hypothesis, which is discussed in Supplement 8-3.
4
K. Murphy, A. Shleifer, and R. Vishny, “The Allocation of Talent: Implications for Growth,” Quarterly Journal of Economics 106 (May 1991): 529.
They do not discuss economists.
5
See P. Romer, “Crazy Explanations for the Productivity Slowdown,” in S. Fischer, ed., NBER Macroeconomics Annual, 2 (1987): 163–201.

228
CASE STUDY EXTENSION

9-4 More on the New Economy

The step-up in economic growth during the last half of the 1990s has raised the question of
whether these gains reflect a payoff from investment in computers and information
technologies. To assess this question, a recent paper by Stephen Oliner and Daniel Sichel
extends the growth-accounting framework presented in the textbook’s appendix to this
chapter.1
The authors take the contribution to output growth from capital accumulation and
break it down into the contribution from information-technology capital (computers,
software, and communications equipment) and the contribution from other forms of capital.
They also separate the output contribution from multifactor productivity growth into a part
arising in the computer (and computer-related semiconductor) industry and a part arising in
the rest of the economy. Oliner and Sichel argue that the accumulation of information-
technology capital reflects the increased use of computers, software, and related equipment
in the production of output, while the gains in multifactor productivity for the information-
technology industry reflect efficiency gains in producing information-technology goods.
Table 1 presents their findings. As shown, about two-thirds of the increase in the rate
of output growth over the period 1996–1999 compared to the period 1991–1995 was due to
either accumulation of information-technology capital or gains in multifactor productivity in
computer-related industries of the economy.2 Interestingly, multifactor productivity also
surged in other sectors of the economy, perhaps in part due to indirect effects of reorganizing
production to take advantage of new information technologies. The authors conclude that
information technology has been an important determinant of the surge in economic growth
during the last part of the 1990s and that the boost to growth from this source is likely to
continue in the near future.3

Table 1 Contributions to Growth of Real Output in Nonfarm

Business Sector, 1974–1999 (annual percentage change)

1974–1990 1991–1995 1996–1999

Growth rate of output 3.06 2.75 4.82
Contribution from:
Capital 1.35 1.01 1.85
Information-technology capital 0.49 0.57 1.10
Other capital 0.86 0.44 0.75
Labor hours and quality 1.38 1.26 1.81
Multifactor productivity 0.33 0.48 1.16
Multifactor productivity in
computer sector plus computer-
related semiconductor sector 0.17 0.23 0.49
Multifactor productivity in
other sectors 0.16 0.25 0.67
Source: Tables 1 and 4 in Stephen D. Oliner and Daniel E. Sichel, “The Resurgence of Growth in the
Late 1990s: Is Information Technology the Story?” Journal of Economic Perspectives, 14, no. 4 (Fall 2000).

1
Stephen D. Oliner and Daniel E. Sichel, “The Resurgence of Growth in the Late 1990s: Is Information Technology the Story?” Journal of Economic
Perspectives, 14, no. 4, (Fall 2000): 3–22.
2
The table reports growth for the nonfarm business sector of the economy. Results, however, would be similar if we considered overall GDP.
3
One caveat to this finding is that the growth rate of the late 1990s may have exceeded the underlying trend rate of growth, and so the long-run effects
on growth may be smaller. See Robert J. Gordon, “Does the ‘New Economy’ Measure up to the Great Inventions of the Past,” Journal of Economic
Perspectives, 14, no. 4 (Fall 2000): 49–74.

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LECTURE SUPPLEMENT

9-5 The Economics of Ideas

Recent work on economic growth emphasizes the importance of human capital. Yet the term
is something of a catchall that is often used to include both embodied skills, such as the
ability to use a word processor or to operate a piece of machinery, and disembodied
knowledge, such as the software code or the blueprint for the machine.
Paul Romer argues that understanding economic growth requires that we think
seriously about ideas, which he claims are quite distinct from other economic goods,
including human capital.1 Ideas “are the instructions that let us combine limited physical
resources in ways that are ever more valuable.”2 Romer uses the metaphors of children’s toys
to illustrate his ideas about ideas.

One of the great successes of neoclassical economics has been the elaboration and
extension of the metaphor of the factory that is invoked by a production function. To be
explicit about this image, recall the child’s toy called the Play-Doh Fun Factory. To
operate the Fun Factory, a child puts Play-Doh . . . into the back of the toy and pushes
on a plunger that applies pressure . . . [O]ut come solid Play-Doh rods, Play-Doh I-
beams, or lengths of hollow Play-Doh pipe.
We use the Fun Factory model or something just like it to describe how capital
(the Fun Factory) and labor (the child’s strength) change the characteristics of goods,
converting them from less valuable forms (lumps of modeling compound) into more
valuable forms (lengths of pipe). . . .
The production function and the Fun Factory metaphor have been widely used in
the neoclassical analysis of aggregate growth. Yet in this analysis the neoclassical
model has been successful primarily at establishing a diagnosis by exclusion. Economic
growth cannot be understood solely in terms of the accumulation of capital and labor—
the fundamental concepts in the underlying metaphor. . . . The formal growth
accounting evidence, historical accounts, and everyday experience all suggest that
something extra, something like innovation, invention, technological change, or the
discovery of new ideas, is needed to understand and explain growth. Yet, having
made this point, the Fun Factory metaphor offers no guidance about what an idea is,
where ideas come from, and how the presence of ideas might matter for development
strategy. . . .
Another child’s toy is a chemistry set. For this discussion, the set can be
represented as a collection of N jars, each containing a different chemical element.
From the child’s point of view, the excitement of this toy comes from trying to find some
combination of the underlying chemicals that, when mixed together and heated, does
something more impressive than change colors (explode, for example). In a set with N
jars, there are 2N – 1 different mixtures. . . . For a moderately large chemistry set, the
number of possible mixtures is far too large for the toy manufacturer to have directly
verified that no mixture is explosive. If N is equal to 100, there are about 1030 different
mixtures that an adventurous child could conceivably put in a test tube and hold over a
flame. If every living person on earth (about 5 billion) had tried a different mixture
every second since the universe began (no more than 20 billion years ago), we would
still have tested less than 1 percent of all the possible combinations. . . .
The potential for continued economic growth comes from the vast search space
that we can explore. . . . There is a branch of physical chemistry that literally cooks up
mixtures from the periodic table of elements. A group of French chemists cooked up one
1
See, for example, Paul Romer, “Two Strategies for Economic Development: Using Ideas and Producing Ideas,” Proceedings of the World Bank Annual
Conference on Development Economics 1992 (Washington, D.C.: World Bank, 1993).
2
Ibid., 64.

230
 Chapter Supplements 231

of the 1030 possible mixtures, one consisting of lanthanum, barium, copper, and oxygen.
More than a decade later, scientists at IBM decided to test the superconductivity
properties of the resulting ceramic. . . . The IBM team won the Nobel Prize in physics
for their discovery that this mixture became a superconductor at temperatures far
exceeding those for all the known superconductors.
This “high-tech” example of a valuable mixture suggests only a small part of the
enormous scope for making discoveries of economic importance. If a garment factory
requires 52 distinct independent steps to assemble a shirt, there are 52! = 1068 different
ways to order these steps in sequence. . . . The number of possible ordering for the 52
assembly operations is the same as the number of possible ways to arrange a shuffled
deck of cards. . . . For any realistic garment assembly operation, almost all the possible
sequences for the steps would be wildly impractical, but even if a very small fraction of
sequences is useful, there will be many such sequences. It is, therefore, extremely
unlikely that any actual sequence that humans have used for sewing a shirt is the best
possible one. . . .
To understand growth, we need to understand not only how big ideas, such as
high-temperature superconductors, are discovered and put to use but also how millions
of little ideas, such as better ways to assemble shirts, are discovered and put to
use. . . .3

Romer goes on to discuss the distinction between objects and ideas. He first considers
public goods, which are defined to be those goods that are nonrival and nonexcludable.
Nonrival means that one person’s use of the good does not preclude another person from also
using that good. Nonexcludable means that we cannot prevent anyone from enjoying the
benefit of a good. The classic example of a public good is national defense. A traditional
private good, such as a pair of shoes, is both rival and excludable. Other combinations are
possible: A fish in the ocean is rival but largely nonexcludable; an encoded satellite television
broadcast is nonrival but excludable. In general, objects are rival goods while ideas are
nonrival goods. But ideas, though nonrival, can be excludable through patent laws and
copyright laws.
As Romer points out, human capital as traditionally defined is both rival and
excludable. An individual cannot be forced to use his or her skills, so they are excludable,
and an individual’s skills cannot generally be utilized by many people at the same time, so
they are rival. Basic research and development, such as is carried out by university
professors, is by and large both nonrival and nonexcludable. According to Romer, we will not
properly understand growth until we understand ideas, and we will not understand ideas
until we are more careful to distinguish them from human capital.

3
Ibid., 67–69.
LECTURE SUPPLEMENT

9-6 Green Growth

There has long been debate among economists, environmentalists, and others about the
effects of economic growth on the environment. Pessimists point to the fact that increased
production of goods and services may imply increased degradation of the natural environ-
ment, both because production uses scarce natural resources and because it generates
pollutants as a by-product. Some, therefore, argue that economic growth should not be an
aim of policymakers. Optimists note that newer, more productive technologies often are less
polluting and use fewer natural resources than older production methods. Moreover, richer
countries may wish to invest more resources in cleaning up the environment. From this
perspective, growth is good for the environment.
The truth seems to be in the middle. Figure 1 reproduces the relationship between
income and the environment for various indicators of environmental quality. For some
aspects of the environment, rich certainly does seem to be better: Rich countries enjoy safe
water and good sanitation while poor countries do not. But the environmental problems of
municipal waste (which fills landfills) and carbon dioxide emissions (which may contribute
to global warming) are relatively worse in richer countries. Perhaps most interestingly,
measures of air quality indicate that air pollution is worst in middle-income countries. As
countries grow, their air quality apparently worsens for a while but then improves when
they become sufficiently rich.
Recent work by Grossman and Krueger supports the idea that economic growth may
initially worsen the level of pollution while continued growth may result in a subsequent
reduction in pollution.1 Their study shows that for most indicators pollution rises until per-
capita income reaches $8,000 and declines thereafter, with air pollution generally peaking
earlier than water pollution. For example, the concentration of sulfur dioxide and smoke in
the air peaks at per-capita income levels of $4,000 and $6,000, respectively. In contrast, the
degree of fecal contamination and nitrates present in rivers peaks at per-capita income
levels of $8,000 and $11,000, respectively.
There is, therefore, no simple answer to the question: Is economic growth good or bad
for the environment? It would be a mistake to dismiss negative environmental consequences
of growth, but it would equally be a mistake to conclude that economic growth necessarily
harms the environment.

1
Gene M. Grossman and Alan B. Krueger, “Economic Growth and the Environment,” The Quarterly Journal of Economics (May 1995): 353–78.

232
 Chapter Supplements 233

Figure 1 B. Urban Population without

A. Population without Safe Water Adequate Sanitation
100 70
80 60
Percent

Percent
60 40
40
20
20
0 0
100 1,000 10,000 100,000 100 1,000 10,000 100,000
Per-capita income (dollars, log scale) Per-capita income (dollars, log scale)

C. Urban Concentrations D. Urban Concentration

of Particulate Matter of Sulfur Dioxide
1,800
Micrograms per cubic

50

cubic meter of air

Micograms per
meter of air

1,200 40
30
600 20
10
0 0
100 1,000 10,000 100,000 100 1,000 10,000 100,000
Per-capita income (dollars, log scale) Per capita income (dollars, log scale)

E. Municipal Wastes Per Capita F. Carbon Dioxide

Emissions Per Capita

600 16
Kilograms

12
Tons

400
8
200
4
0 0
100 1,000 10,000 100,000 100 1,000 10,000 100,000
Per-capita income (dollars, log scale) Per-capita income (dollars, log scale)

Note: Estimates are based on cross-country regression analysis of data from the 1980s. (F) Emissions are from fossil fuels.
Source: World Bank, World Development Report 1992: Development and the Environment (New York: Oxford University Press, 1992), 11.
ADDITIONAL CASE STUDY

8-7 Corruption and Growth

The Solow model does quite a good job of explaining differences in living standards and
growth rates among different countries. But it is not perfect, so many economists have
sought additional explanations of the varying economic performance of different countries.
Paolo Mauro has investigated the link between growth and the incidence of bureaucracy and
corruption.1
Mauro uses data gathered by Business International, a private company that surveys
analysts in many different countries about political, bureaucratic, and other factors that
might influence the attractiveness of a country to investors. He combines assessments of the
degree of red tape, the extent of corruption, and the integrity of the judicial system into a
measure that he terms bureaucratic efficiency (BE). Countries such as the United States,
Finland, Japan, New Zealand, and Singapore do well in terms of the BE index; countries like
Egypt, Haiti, Indonesia, Nigeria, and Thailand do poorly.
Figure 1 is a scatterplot of BE and per-capita income in 67 countries. There is a clear
positive association: Countries with high levels of corruption and bureaucracy tend to have
lower income. Of course, it might be the case that high-income countries develop better
institutions. But Mauro’s statistical analyses suggest that the link does indeed run the other
way: More corrupt countries tend to be poorer and also tend to grow more slowly.

Figure 1 Per-Capita
Per Income and
Capita Income and Bureaucratic
Bureaucratic Efficiency
Efficiency
20
Kuwait

15
(thousand)
- US$ (thousand)

Saudi Arabia United States

capita—US$

Germany Switzerland
10 France
percapita

Austria
Italy
GDPper

Trinidad
New Zealand
GDP

Spain Israel

5 Mexico Iraq Ireland Singapore

South Africa
Iran Brazil Chile
Thailand Jordan
Philippines
Haiti
Zaire Indonesia Zimbabwe
0
0 2 4 6 8 10
Bureaucratic Efficiency (BE) index

1
P. Mauro, “Corruption and Growth,” The Quarterly Journal of Economics, 105, 3 (August 1995), 688.

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LECTURE SUPPLEMENT

9-8 Income Inequality and Growth

Is there a tradeoff between economic growth and the distribution of income? Must a country
accept a more unequal distribution of income in order to achieve a high rate of economic
growth? Recent studies reject this tradeoff and agree instead that a more equal distribution
of income results in higher economic growth.1
Persson and Tabellini (1994), for example, examine the effects of the distribution of
income on the growth of per-capita income in 56 countries between 1960 and 1985.2 In their
model, as is standard in this literature, average growth in each year between 1960 and 1985
is determined by the initial level of GDP per capita, the initial level of human capital (as
measured by schooling), and the initial distribution of income before taxes. Their results
show that the higher the initial level of GDP, the lower is the growth rate of the economy,
which supports the idea of convergence. Furthermore, the higher the education level of the
population, the higher is the growth rate of the economy. Persson and Tabellini also find
that the more equal the distribution of income in a country in 1960, the higher was its rate
of economic growth during 1960–1985. Increasing the share of income going to the middle
class by 3 percentage points raised the annual growth rate by over one-half a percentage
point.
Should governments then adopt policies aimed at achieving a more equal distribution
of income? To answer this question we need to determine why income inequality lowers
growth. One linkage is through human capital development.3 If education is costly to obtain
(either because of the lack of adequate public education or the cost of forgone wages), then
only the wealthy will invest in education. Countries with a more unequal distribution of
income will have lower average levels of education, which in turn reduces growth.
Two other lines of research link income equality and growth through political channels.
One theory is that a more unequal distribution of income leads to higher taxes and
transfers.4 The poorer the majority of the electorate the more likely it is that they will vote to
increase taxes to support transfers.5 High taxes in turn reduce the incentive to work and
invest and thus lower growth. If this theory is correct, then government policies aimed at
reducing inequality may worsen growth.
The other line of research argues that the more unequal the distribution of income in a
country, the greater the likelihood of political instability.6 This instability in turn reduces
the incentives to save and invest and thus lowers growth. In this case, government policies
aimed at greater equality will raise growth.
So far, there is no consensus on the link between inequality and growth. Further
research may find that all or none of these three possible links are important. Thus, while
there is some evidence that a more equal distribution of income promotes growth, we do not
yet fully understand the mechanism underlying this linkage. Recent findings are provocative
but do not necessarily mean that governments should try to reduce inequality as a means of
promoting growth.

1
Summaries of this research are presented in Alberto Alesina and Robert Perotti, “The Political Economy of Growth: A Critical Survey of the Recent
Literature,” The World Bank Economic Review 8, no. 3 (September 1994): 351–72; and Roberto Chang, “Income Inequality and Economic Growth:
Evidence and Recent Theories,” Federal Reserve Bank of Atlanta Economic Review 79, no. 4, (July–August 1994): 1–10.
2
Torsten Persson and Guido Tabellini, “Is Inequality Harmful for Growth?” The American Economic Review 84, no. 3 (June 1994): 600–21.
3
See, for example, Oded Galor and Joseph Zeira, “Income Distribution and Macroeconomics,” Review of Economic Studies 60 (1993): 35–52.
4
See, for example, Alberto Alesina and Dani Rodrik, “Distributive Politics and Economic Growth,” Quarterly Journal of Economics 109 (1994): 465–90;
and Torsten Persson and Guido Tabellini, “Is Inequality Harmful for Growth?” The American Economic Review 84, no. 3 (June 1994): 600–21.
5
This argument requires that the political power of each member of the electorate be equal, and that the poor vote.
6
See, for example, Alesina and Perotti, “Income Distribution, Political Instability, and Investment,” National Bureau of Economic Research Working
Paper no. 4486 (1993).

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LECTURE SUPPLEMENT

9-9 The Solow Growth Model: An Intuitive Approach—Part Two

This supplement continues the more intuitive and less mathematical explanation of growth
models.

Technological Progress
In general, technological progress can take many different forms. By far the easiest form to
analyze is labor-augmenting technological progress. We write the production function as
Y = F(K, E × L).
The new variable, E, represents the efficiency of labor, which depends on the skills and
education of the workforce. The idea is that a more skilled and better trained workforce can
produce more output with a given capital stock. (As an example, think of capital as
consisting of personal computers and labor efficiency as being knowledge of software
packages.) We represent technological progress as an exogenous increase in the value of E
through time. That is, we suppose that E grows at the rate g. Over time, even if K and L are
constant, each worker will be able to produce more and more output—for example, a 2-
percent improvement in the efficiency of labor means that 98 workers can now do a job that
used to require 100 workers. The product E × L measures effective workers.
The key to the analysis in this case is that changes in labor efficiency act exactly like
changes in population. Just from looking at the production function, it is evident that
changes in E must affect output in just the same way that changes in L affect output. If we
have 2-percent population growth and no technological progress, then E × L grows at 2
percent; likewise, if we have no population growth and 2-percent technological progress,
then E × L grows at 2 percent.
Suppose, therefore, that population growth is zero and technological progress is at the
rate g. By following the same reasoning used in the case of population growth, we see that K
must grow at the rate g in steady state. Output also grows at the rate g. In this steady state,
capital per effective worker—K/(E × L)—is constant. The only difference from the previous
analysis is that the actual capital–labor ratio, K/L, now grows through time at the rate g,
implying in turn that output per person now grows at the rate g. Thus, this model can finally
explain rising living standards.

Putting the Pieces Together

We can now summarize the Solow model when all three sources of growth—changes in
capital, changes in labor, and changes in technology (labor efficiency)—are present.
Suppose that the population is growing at the rate n (say, 1 percent per year), and the
efficiency of labor is growing at the rate g (say, 2 percent per year). Then effective workers (E
× L) are growing at the rate (n + g), which equals 3 percent per year. Since capital per
efficiency unit of labor is constant in steady state, it follows that the capital stock must also
be growing at 3 percent per year. Consequently, total output will be growing at 3 percent per
year. Although capital per effective worker is constant, capital per person (the capital–labor
ratio) is growing at 2 percent per year. Similarly, output per person and consumption per
person are also growing at 2 percent per year in this steady state.

Growth Accounting
Robert Solow, the inventor of the Solow growth model, also pioneered an accounting tech-
nique to measure how much of overall economic growth is explained by changes in capital,
changes in labor, and changes in labor efficiency. The effect on output of an increase in, say,
the capital stock obviously depends on the nature of the production function F(K, E × L), and
it might seem that we cannot quantify such changes without a lot of information on the
production function. Remarkably, we can measure these effects if we are prepared to make

236
 Chapter Supplements 237

two assumptions: (1) The production function exhibits constant returns to scale; and (2)
capital and labor are paid their marginal products, as in the classical model of Chapter 3.
Solow showed that the percentage change in output due to a 1-percent change in capital
equals capital’s share of output and the percentage change in output due to a 1-percent change
in labor equals labor’s share of output. (The details are in the Chapter 8 appendix in the
textbook.) Recall that total income equals wages plus profits. Capital’s share of output is
simply equal to profits as a fraction of income; labor’s share is wages as a fraction of income.
For the United States, capital’s share is about 1/3 and labor’s share about 2/3.
Over the last 40 years, labor input has grown at approximately 1.5 percent per year.
The resulting increase in output equals 1.5 multiplied by 2/3—about 1 percent per year. The
capital stock has grown at about 3 percent per year. The increase in output associated with
increased capital equals 1/3 of 3 percent—again, about 1 percent per year. But total output
has grown by about 3 percent per year. Since changes in capital and labor each account for
about 1 percent, it follows that 1 percentage point of growth per year cannot be accounted for
by changes in capital or labor. This remaining 1 percent is called the Solow residual, and is a
measure of technological progress. In terms of our model, we can conclude that labor
efficiency must have grown at about 1.5 percent per year. (For more precise figures, see
Table 8-3 in the textbook.)

Policy Implications
An important message conveyed by the Solow growth model is that increases in the rate of
saving are not necessarily desirable. There are two reasons for this. First, beyond a certain
point, increases in the saving rate actually lower consumption in the long run. The reason is
that with a very high capital stock we may have to devote so much output simply to
replacing worn-out machines that not very much is left over for consumption. Beyond a point
known as the Golden Rule, increases in the capital–labor ratio decrease steady-state
consumption. An economy in such a position would actually want to decrease its saving rate,
since this allows present and future generations to enjoy increased consumption.
Second, even for an economy with a steady-state capital–labor ratio below its Golden
Rule value, raising the saving rate may be difficult to achieve. In this case, an increase in
the saving rate does ultimately raise output and consumption, but in the short run,
higher saving lowers consumption since it takes time for the capital stock and output to
rise. People reap the benefits only when output has increased enough so that they can
consume more even with their higher saving rate. An increase in the saving rate thus
involves a tradeoff between a short-run cost and a long-run gain, perhaps implying
intergenerational conflict. It is not obvious that higher saving is desirable.
The Solow model teaches that the ultimate source of sustained growth is technological
progress. The only policies that affect long-run growth are, therefore, those that influence
the development of skills and of knowledge. For this reason, some analysts argue for
increased investment in education, training, and research and development. But because
economists do not yet have a complete understanding of the sources of technological
progress, we cannot yet guide policy in this area with a great deal of confidence.

What Have We Learned?

The Solow model explains the forces that lie behind the accumulation of capital in an
economy, and it helps us to understand how changes in capital, labor, and technology all
contribute to economic growth. It also helps explain differences in living standards across
countries: the model predicts that, even if all countries have access to identical technology,
we might expect to see higher standards of living in countries with higher saving rates and
lower population growth rates. The model teaches the surprising lesson that higher saving
rates do not affect economic growth in the long run (although they do affect the overall level
of income). Finally, the model clearly reveals that economic growth concerns the choice
between current and future consumption: We can enjoy higher standards of living in the
future if we are prepared to save more—that is, consume less—today.
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8 Economic Growth II

Yet, in many ways, the Solow model is unsatisfactory. One of the most striking facts of
macroeconomics is that almost all countries in the world have enjoyed sustained increases in
living standards. The Solow model’s only explanation of this is exogenous technological
progress—which is not really an explanation at all. Moreover, there are many features of
observed economic growth that are not well explained in the Solow model. For example,
different countries in the world have experienced markedly different rates of economic
growth: Many countries have seen sustained increases in per-capita income of over 5 percent
per year, while a few have experienced little or no growth. The Solow model cannot easily
explain such differences. Also, the Solow model predicts that, in general, poor countries
should grow more quickly than rich countries, and so catch up with them, yet the data do not
yield strong evidence of such convergence.

Endogenous Growth Theory

Recent work on economic growth seeks to fix the weaknesses of the Solow growth model. One
area, known as endogenous growth theory, attempts to directly incorporate the process
driving sustained economic growth rather than relying on exogenous technological progress.
In the Solow growth model, an increase in the rate of saving does not affect economic
growth in the long run because of diminishing returns to capital. One way to get around this
problem is to assume that each unit of capital produces a constant amount of output
Y = AK.
So, if A = 2, adding one unit of capital always yields two additional units of output.
Because in this model adding more and more capital does not result in smaller and
smaller increases in output (diminishing returns), increases in the saving rate forever
increase the growth rate of income (persistent economic growth).
This model makes sense only if we think of capital, K, as consisting of more than the
stock of plants and equipment. If knowledge is considered a type of capital, then abandoning
the idea of diminishing returns to capital is not unreasonable.
Another version of an endogenous growth model views the economy as consisting of two
sectors: firms that produce output, Y, for consumption and investment in physical capital, K;
and research universities that produce knowledge, E, that in turn is used to produce output
or more knowledge. The production function for the manufacturing sector is
Y = F (K, (1 – u) E* L ).
The only difference between this production function and the production function for the
Solow growth model incorporating technological progress is that now only a fraction of the
labor force (1 – u), works in the manufacturing sector. The other fraction of the labor force,
u, produces knowledge.
If the division of the labor force between the two sectors remains constant, then the
model is similar to the Solow growth model. The saving rate, s, determines the steady-state
stock of physical capital. The fraction of the labor force devoted to research, u, determines
the growth in the stock of knowledge. Both s and u determine the level of income, while the
long-run growth rate is determined by u.
In endogenous growth models, R&D benefits society by raising the stock of knowledge.
Firms that engage in R&D, however, also receive private benefits through increases in
profits. Empirical studies indicate that the social benefits of R&D are greater than the
private returns. This has led some economists to argue for government subsidies for R&D.
LECTURE SUPPLEMENT

9-10 Additional Readings

The more recent work on endogenous growth theory is for the most part quite difficult. There
is a useful symposium in the Winter 1994 Journal of Economic Perspectives. A very brief and
relatively accessible history of growth theory, including some recent developments, is
provided by Nicholas Stern, “The Determinants of Growth,” Economic Journal 101 (January
1991): 122–33. (This edition of the Economic Journal is also of interest because it contains
the prognostications of a number of famous economists concerning the next 100 years of the
discipline.)
A major survey that inspired much subsequent work on the productivity slowdown and
the convergence hypothesis is provided by Angus Maddison, “Growth and Slowdown in
Advanced Capitalist Economies,” Journal of Economic Literature 25 (June 1987): 649–98.
The Fall 1988 issue of the Journal of Economic Perspectives contains a symposium on
the productivity slowdown. Paul Romer also suggests that endogenous growth theory may
help to explain the productivity slowdown; see P. Romer, “Crazy Explanations for the
Productivity Slowdown,” in S. Fischer, ed., NBER Macroeconomics Annual 2 (1987): 163–220
(Cambridge, Mass.: MIT Press, 1987). The May 1990 American Economic Review, Papers
and Proceedings contains short and readable papers on endogenous growth theory by Gene
Grossman and Elhanan Helpman, Robert Lucas, and Paul Romer. The Federal Reserve
Bank of Kansas City published a symposium on Policies for Long-Run Economic Growth in
August 1992.
For a discussion of the role information technology has had in the growth performance
of the late 1990s, see the Fall 2000 issue of the Journal of Economic Perspectives, which
contains a symposium on computers and productivity. Also see Dale Jorgenson’s presidential
address to the American Economic Association, entitled, “Information Technology and the
U.S. Economy,” which appears in the March 2001 issue of the American Economic Review.

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