ECONOMIC GROWTH:

ACCUMULATION & POLICY

Macroeconomics (EKO 503)
Lecture II-III
Prof. Hermanto Siregar

GROWTH & ACCUMULATION

Over the period 1820-1998:

income

per capita of the US had

increased more than sixteen fold
Japan has gone from being a
moderately poor country (before WW
II) to being a wealthy country with a
standard of living that of the US
income per capita of Norwegian has
spurted in the last 25 years.

But Ghana was very poor 100 years

agoand growthlesssadly
remains that way today. Why?
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Growth Accounting
Output grows through increases in inputs
and increases in productivity due to
improved technology.
Y = A.F(K, N) Y = K (AN)1-
Y is output, A the level of technology
(productivity), K capital, and N labor.
Growth accounting equation:
Y/Y = [(1-) N/N] + ( K/K) + A/A

Output
Growth

Labor
Share

Labor
Growth

Capital
Share

Capital
Growth

Technical
Progress
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Growth accounting equation summarizes

the contributions of input growth and of
improved productivity to the growth of
output

labor and capital each contribute an amount

equal to their individual growth rates multiplied
by the share of that input in income
The rate of improvement of technology
(technical progress) the growth of total
factor productivity (TFP)
The growth rate of TFP is the amount by which
output would increase as a result of
improvements in production methods, with all
inputs unchanged.
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Accounting for Growth in Per Capita Output

Per Capita GDP = GDP / Population or: y Y/N

Y/Y = y/y + N/N

Capital labor ratio: k K/N
K/K = k/k + N/N
The growth accounting equation can thus
be rearranged to:
Y/Y N/N = [K/K N/N] + A/A

which in per capita term is:

y/y = k/k + A/A.
is around 0.25 1% increase in the
amount of capital per worker increases
per capita output by only 0.25%.
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Factors Other than Capital and Labor

Natural resources
Much

of early prosperity of the US was

due to its abundant fertile land. During
1820-1870, the land grew by 1.41%
p.a. contributing greatly to growth
During 1970-1990, Norways per capita
GDP rose from 61% of US per capita
GDP to 77%. Much of this growth spurt
was due to discovery and development
of massive oil reserve
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Human capital

Raw labor is less important than skilled and

talented labors
Societys stock of such skills is increased by
investment in human capital through schooling,
on-the-job training etc.
In LDCs, investments in health are also major
contributor to human capital.

Production function with human capital (H):

Y = A.F(K, H, N)

Mankiw, Romer & Weil: such production

function is consistent with factor shares of one
third each for K, H and N. Growth in these
factors explain about 80% of variation in GDP
per capita critical role of factor accumulation
in the growth process.
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Growth Theory: the Neoclassical Model

Neoclassical growth theory focuses on

capital accumulation and its link to
savings decisions. Endogenous growth
theory focuses on the determinants of
technical progress.
The best-known contributor of the
neoclassical growth theory is Robert
Solow.
The theory begins with an assumption
that no technical progress, and that the
economy is at the steady-state
equilibrium.
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An economy is at steady state when per

capita income and per capita capital is
constant y=0 & k=0. Their values
are: y* & k* values where the
investment required to provide capital for
new workers and replace machines that
have worn out is just equal to saving
generated by the economy.

If saving > required investment k increases

and therefore output does as well.
If saving < required investment k falls and
output also falls.
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Per Capita Production Function

y
y = f(k)

y*

k*

Capital labor
ratio (k)

As capital rises, output

rises (MP of capital is
positive), but output
rises less at high
levels of capital than
at low levels
(diminishing MPK)
law of diminishing
marginal product.

The Cobb-Douglas production function: Y = A.KN1-

Per capita production function: Y/N = A.KN1-/N
= A.KN-N/N = A(K/N)
Therefore,

y = A.k
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Investment and Saving

The investment required to maintain a

given level of capital per capita (k)
depends on population growth (n N/N)
and depreciation rate (d) (n+d)k.
Assuming no government sector, no
foreign trade and capital flows, and
constant saving rate (s), per capita saving
= s.y = s.f(k)
The net change in capital per capita is the
excess of saving over required investment:
k = s y (n + d) k
At the steady state, k = 0, thus:
s y* = s f(k*) = (n + d) k*
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Steady State Output and Investment

y
y*
y0
sy0

D
C

y = f(k) (production function)

(n+d)k (investment requirement)
sy (saving or actual invt)

k0

k*

At C, saving and required

investment balance with
steady state capital k*.
Steady state income is at
D at the level y*.

If the economy starts at k0 (where saving at A exceeds the

required investment at B), k accumulates to reach k* (the
horizontal arrow shows k increasing). The opposite is when k
is at the right of k*.
The adjustment process comes to a halt at C, where the
saving matches the required investment.
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An Increase in Saving Rate

Output per head

y**
y*

sy

k*

f(k)
(n+d)k
sy

k**

capital
per head

If the saving rate

increases (s to s),
the steady state
capital-labor ratio
increases (k* to k**).
Output per capita
then increases from
y* to y**.

The increased saving rate in the short run raises the growth
rate of output per head. In the long run, however, it does
not affect the growth rate of output per capita.

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Output per Head

Adjustment to New Steady State

y**

y*
t1

Growth Rate

t0

Time

n
t0

t1

Time

For income
per capita
and capital
per capita to
remain
unchanging
even though
population is
growing,
income and
capital must
grow at the
same rate as
population:
Y/Y =N/N
=K/K = n.
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Population Growth

An increase in population growth

affects the required investment
curve: (n+d)k so as to rotate it up
and to the left
reduces

the steady state level of capital

per head and output per head
increases the steady state rate of
growth of aggregate output.

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Growth with Exogenous Technological Change

Output per Head

y1 = f(k, A1)

A is TFP.

y0 = f(k, A0)
(n+d)k
sy1
sy0

k0*

k1*

Capital per
Head

The technology
grows with the
rate: g=A/A
This is a labor
augmenting
the new technology raises
the productivity
of labor.

The last equation on page 5 then becomes:

y/y = k/k + (1-) g or: g = (y/y k/k) / (1- )

The Solow residual: g (y/y k/k)

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GROWTH AND POLICY

Endogenous growth theory

Neoclassical growth theory dominated

economic thought for 3 decades, but by the
late 1980s it resulted dissatisfaction.
Theoretically, the theory attributes LR growth
to technological progress but leaves
unexplained the economic determinants of
such technical progress
Empirically, growth and savings rates should
be uncorrelated in the steady state, but the
data make it clear that savings rates and
growth are positively correlated across
countries.
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The solution to the dissatisfaction on the

neoclassical theory lies in modifying the assumed
shape of the production function in a way that
allows for self-sustaining (endogenous) growth.
Remember the figure on page 12.

Anywhere the savings line is above the investment

requirement line, the economy is growing because
capital is being added. Starting from A, the
economy moves to the right, approaching the
steady state, and halts at C.
This is guaranteed to occur because the shape of
saving and production curves exhibit the
diminishing MP of capital the investment
requirement line and saving curve are guaranteed
to cross.
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Endogenous Growth Model

Output per head

f(k)
s.f(k)
(n+d)k
Saving is always >
required investment.
The higher s, the bigger the gap of
saving above required investment,
and the faster is growth.

Capital per head

K = s.Y = s.a.K

or:

The (simple)
production function
exhibits a constant
MP of capital:
Y=aK
hence MPK = a.
With no population
growth nor
depreciation of K,
and constant s, then:

K/K = s.a

Hence the growth rate of capital is proportional to the savings

rate. Since output is proportional to capital, then the growth
rate of output is:
Y/Y = s.a the higher savings rate, the higher the growth.
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Elimination of diminishing marginal

returns violates deep microeconomic
principles.

The changed assumption implies CRS for

capital doubling K doubles Y
So doubling all production factors (K and L)
will more than double Y if there is CRS to
capital alone, there will be IRS to all factors
taken together larger and larger firms are
more efficient, so a single (largest) firm should
dominate the entire economy not happening

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Thus we ought to rule out the possibility of

IRS to all factors and CRS to an input, at
least for a firm.
Suppose a firm doesnt capture all the
benefits of K the firm production rises
but so does the productivity of other firms.
As long as the private return has CRS to all
factors, there will be no tendency to
monopolization.

Paul Romer separates private returns to K from

social returns. Investment produces not only
new machines but also ways of doing things
Firms do capture production benefits of new
machines, but
much harder to capture benefits of new ideas &
new methods because they are easy to copy.
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Convergence

Such question centers on whether economies

with different initial levels of output eventually
grow to equal standards of living.
Neoclassical growth theory predicts absolute
convergence for economies with equal rate of
savings and population growth and with access
to the same technology they eventually
reach the same steady state even if one
economy begins farther to the left.
Conditional convergence is predicted for
economies with different rates of savings or
population growth steady state incomes will
differ as predicted by the Solow growth
diagram, but growth rates will eventually
equalize.
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Robert Barro (1997) has shown that while

countries that invest more tend to grow
faster, the impact of higher investment on
growth seems to be transitory. Countries
with higher investment will end in a
steady state with higher per capita
income but not with a higher growth rate.

Thus countries do converge conditionally.

So endogenous growth theory is not very
important for explaining international
differences in growth rates.
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Growth Policy

is the policy for moving countries from

underdeveloped to developed status.
The Solow growth model predicts that high
population growth (n) means lower steady state
income because each worker will have less capital
to work with. However, over a wide range of
incomes, population growth itself depends on
income.

Extremely poor countries have very high birth rates

as well as death rates moderately high population
growth
As income rises, death rates fall and population
growth rises. At very high incomes, birth rates fall
wealthier countries approach ZPG.
Thus some governments apply population control
policy.
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The Asian Tigers (especially Hong Kong,

Singapore, South Korea, and Taiwan)
have experienced high growth. The
special trick for this is old fashioned hard
work and sacrifice.

These countries have not had remarkable

increases in TFP
They have saved and invested, put more
people to work, and concentrated on education
in order to rise human capital.

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Growth in the Asian Tigers (%)

(Alwyn Young, 1995)
H.Kong
(1966-91)

Spore
(1966-90)

S. Korea
(1960-90)

Taiwan
(1960-90)

GDP per capita

growth

5.7

6.8

6.8

6.7

TFP Growth

2.3

0.2

1.7

2.6

3849

2751

2736

2837

2771

1666

2775

2668

% Labor Force
Participation
% Secondary
Education or
Higher

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Reform and Growth in Eastern Europe

In the 1990s, the formerly communist

countries of Eastern Europe and Soviet
Union ended the highly centralized
planning system. The basic reforms
strategies are:

Restore macroeconomic stability budget

close to balance, TMP and credit policies
Liberalize prices removing price controls
Privatize SOEs
Liberalize foreign trade open access to the
world market
Establish a social safety network people who
become unemployed do not become destitute
Develop contract & bankruptcy laws.
[The End]
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