Macro 4

Macroeconomic Development Policy-I
Seid Nuru
sali1@uni-bonn.de
Zentrum für Entwicklungsforschung (ZEF)
2009
Course Outline
• Introduction
• National Income Accounting
• Income Determination in a Closed Economy
• Income Determination in the Open Economy
• Economic Growth
• Output, Inflation, and Unemployment
2
V. Economic Growth
> Introduction
The Neoclassical Growth Model
Economic Growth The Endogenous Growth Models
Definition
• Economic growth is defined as a sustainable rise in real
GDP.
• Growth in strict sense does not refer to expansion of output
for a brief period of time.
• In this context, growth has to be understood in the long-
run.
• Growth rate of GDP at a given time (year or quarter) can
be calculated as:
æY t - Y t - 1 ö
÷
g = çç ÷
÷.100 (1)
çè Y t - 1 ø ÷
where Yt =GDP.
4
> Introduction
Definition: Measuring Growth

• Given the formal definition for growth, we are required to determine
the growth rate for a longer period.
• Given the annual growth rates of real GDP, gi, the average growth rate
over T period is givenT by:
å gi
g av = i= 1
T
(2)
• Under this approach, we are implicitly assuming that the variable at
hand (in this case GDP) is compounded annually. That is,
Y1 = Y0 + gY0 = Y0 (1 + g )
2
Y2 = Y1 + gY1 = Y1 (1 + g ) = Y0 (1 + g )
. . . . .
t
Yt = Yt- 1 + gYt- 1 = Yt- 1 (1 + g ) = Y0 (1 + g )
so that:
Y t - Y t - 1 Y 0( 1 + g )t - Y 0( 1 + g )t - 1
Growth = = = 1+ g - 1 = g
Yt-1 Y 0( 1 + g ) t - 1
5
> Introduction
Definition: Measuring Growth

• GDP can also be thought to be compounded continuously. Let  be
instantaneous growth rate. Then,
Yt = Y0 e b t (3)
where Yt =GDP.
• Taking logs:
Þ ln Yt = ln Y0 + b t
=q + b t
• By applying the derivative, it is easy to see that  is instantaneous growth:
ædY ö÷
çç ÷
d ln Yt çè Y ø÷
growth = = = b
• dt dt
Using ordinary least squares, we estimate the trend:
ln Yt = q + b t .
• Show that
g = e b - 1.
6
> Introduction
Definition: Growth Decomposition by Sector

• Growth in GDP can be decomposed by sector.
• Letting Y = GDP, YA , YI , and Ys are value-added in the
agricultural, industrial, and service sectors, it is possible to
show that:
æYA ö æYI ö æYS ö
ç
g = g A .ç ÷ ÷ ç ÷ ç ÷
÷+ g I .èçç Y ø
÷+ g DS .ççè Y ø
÷ ÷
çè Y ø (4)÷
where g = growth rate in GDP and gi is the growth rate of the value-added
in the ith sector, Yi/Y is the share of the ith sector in GDP.
7
> Introduction
Definition: Growth in Per capita GDP

• Let yt = per capita income, Nt = population; then:
Yt (7)
y =
t
Nt
• Taking the logarithm of the per capita income and applying the first
order derivative, we have:
d ln yt = d ln Yt - d ln Nt
dyt dYt dNt
= -
y Yt Nt
g y = gY - g N (8)
Growth in per capita income (gy) = growth in GDP (gY )– growth in

population (gN).
8
> Introduction
Stylized Facts of Growth

• There is tremendous difference in per capita income across
countries.
– The poorest countries have per capita incomes that are less than 5
percent of per capita incomes in the rich countries.
• Economic growth rates vary across countries.
• Growth rates in per capita income are not necessarily
constant over time.
• A country’s position in terms of income in the world is not
constant. That is, poor countries can be rich and rich
countries can be poor.
9
> Introduction
Growth Theories
• The formal starting point for the analysis of growth in
addressing the above stylized facts is the neoclassical growth
model.
• One of the important conclusions of the neoclassical
growth model is that the source of long run growth is
technology.
• However, technology remained to be exogenous
(unmodelled) in the neoclassical growth model.
• Other growth theories under a name of endogenous growth
theories have been developed in an attempt to endogenize
technology.
10
Introduction
> The Neoclassical Growth Model
The Endogenous Growth Models
Economic Growth
The Basic Solow Growth Model

• The Solow growth model is based on two fundamental
equations.
– Production function (from the supply side)
– Capital accumulation equation (from the demand side)
The Production Function
• He used the Cobb-Douglass production function.

•
Y = F ( K , L ) = K a L 1- a (9)
Where Y= output, K = capital, L = labor.
• Assume for simplicity that labor force equals population.
11
Introduction
Economic Growth
The Solow Growth Model: The Production Function

• Assumptions:
1. Constant returns to scale: The production function is homogenous
of degree one. That is, it has a constant returns to scale, and as
such scaling up of inputs by a factor z scales up output by the
same factor z.
2. Diminishing returns to factor inputs: As factor inputs (labor and
capital) increase, output increases but the rate at which output
increases tends to decline as more of each input is used while
either of the two is held to be constant.
3. The Innada conditions: Marginal product of inputs approaches
infinity as inputs tend to reach zero and approaches zero as inputs
tend to infinity.
12
Introduction
Economic Growth
The Basic Solow Growth Model: The Production Function

• The production function can be expressed in
per capita terms:
a y
Y K L a 1- a
æK ö
÷
= = ççç ÷
L L èL ÷
ø MPk2 y = ka
a
Þ y = k (10) 1
MPk1
¶ 2y
where ¶ y > 0and .2 < 0 1
¶k ¶k k
• The last restrictions say that there is a
MPk
diminishing marginal product of capital.
• That is, firms produce more output by
hiring in more capital for each worker. But
eventually each additional unit of capital
per worker brings about less and less
additional output per worker. k
13
Introduction
Economic Growth

The Capital Accumulation Equation
• From the demand side, assuming a closed economy, output

produced (Y) is either invested (I) or consumed (C).
Y= I+ C (11)
• Consumption is a function of income:
(12)
C =marginal
where cY º (1propensity
- s)Y to consume (MPC), marginal
propensity to save (MPS).
• This implies:
Y = (1- s )Y + I
Þ I = sY
(13)
14
Introduction
Economic Growth
The Basic Solow Growth Model: The Capital Accumulation Equation

• Capital accumulated at time t, Kt is equal to the previous
period’s level of capital Kt-1 plus gross investment It less
depreciation of previous capital stock Dt.
• Let the previous capital stock depreciates at a constant rate of
 so that Dt = Kt-1. Then we have:
K t = K t - 1 + I t - dK t - 1 (14)
• Rearranging this equation,
K t - K t - 1 = I t - dK t - 1
Þ D K t = I t - dK t - 1
(15)
• In continuous form, we have:
dK
= I - dK
dt
K& = sY - dK (16)
dK
&
K = and I = sY .
where dt
15
Introduction
Economic Growth

• The capital accumulation equation can be expressed in per
capita terms:
K
k = Þ ln k = ln K - ln L (17)
L
• Taking the derivative of lnkt with respec to to time:
d ln k d ln K d ln L
= -
dt dt dt
ædk ÷ö ædK ö ÷ ædL ö
çç ÷ çç ÷ çç ÷ ÷
èdt ÷
ø è dt ø÷ èdt ø ÷
Þ = -
k K L
dk & dK & dL
• Let us denote = k; L&
= K; so=that:
dt dt L
k& K& L&
= - (18)
k K L
16
Introduction
Economic Growth

• Combining Equations (16) and (18), we have:
k& sY L&
= - d-
k K L (19)
• Labor, L, evolves over time according to the equation:
Lt = L0e nt (20)
where n is the labor force (population) growth rate, so that:
d ln Lt L&
= = n
• Substituting
dt Ln in Equation (19):
(21)
k&= sy - (d + n)k
17
Introduction
Economic Growth

• In the capital accumulation equation:
k&= sy - (d + n)k
the change in capital per worker kis&determined by:
– Investment per worker, sy, which tends to increase it;
– Depreciation per worker, k, which tends to reduce it;
– Rise in population which reduces it by a magnitude of nk.
• As nL new workers come into the economy, assuming that there is
no depreciation, and no new investment made, then, there is a
decline in capital per worker by nk amount.
18
Introduction
Economic Growth
The Steady State
• So far, we have developed two important equations:

– The production function (in per capita terms): y = ka
– The capital accumulation equation (in per capita terms):
k&= sy - ( d + n)k
• The next question is:
– How does an economy evolve over time?
– How does output per worker grow?
– What explains the difference in income across countries?
19
Introduction
Economic Growth
The Basic Solow Growth Model: The Steady State

• Let us transform the two equations
into graphs.
• The difference between the graphs y
representing (n+)k and sy is the
change in the amount of capital per
worker. y
y*
• When this change is positive, capital c* ( n + d)k
per worker increases and we say sy * sy
capital deepening is occurring.
• When the change is zero while the
actual capital stock K is increasing *
k
(why?), we say that only capital k
widening is occurring.
Introduction
Economic Growth

• Suppose that an economy has a
capital stock per worker, k0.
• Over time, at k0, the amount of y
investment per worker exceeds the
amount required to keep capital per
worker constant, so that capital * y
y
deepening occurs increasing k. c* ( n + d) k
• This capital deepening continues sy * sy
A
until k = k* at a point where
investment per worker equals
depreciation of capital per worker. k
k0 k *
• It occurs at point A where k &=and
0
the amount of capital per worker
remains constant.
Introduction
Economic Growth

• If the economy were to start at a capital per worker of k*, then, it
would remain there! The reason is diminishing returns to capital
which creates a downward movement in the output -capital ratio
as capital is accumulated faster than labor.
• The lower output –capital ratio then brings down the growth of
capital in line with the growth of labor.
• This means the long-run capital-labor ratio must be constant.
• Since per capita income is a function of capital ( y =),kwhen
a
capital per worker settles down to some steady state level, so does
per capita income. This level is called a steady state.
A steady-state is a situation where variables involved grow at a

uniform constant possibly zero rates.
• At a steady-state, physical accumulation gives way to physical
maintenance.
Introduction
Economic Growth

• Corresponding to the steady state level of capital per
worker, there are steady state level of output per worker, y*
and steady state level of consumption per worker, c*.
• The steady state consumption per worker is the difference
between the steady state output per worker and the steady
state investment per worker.
c = y - sy º(22)(1 - s ) y
* * * *
23
Introduction
Economic Growth

• At steady state, k&= . 0This implies that sy - ( d +. n )k = 0
a
• Noting that y = , kthe steady state level of capital per worker
is:
1
æ s (23)
ö÷ 1- a
*
ç
k = çç ÷
èn + d ø÷
• Substituting this result into the production function, we have

the steady state level of per capita income:
a
(24)
æ s ö÷ 1- a
y = ççç
*
÷
èn + d ø÷
24
Introduction
Economic Growth

Comparative Statics
• Given the steady state level of per capita output,
what will happen to it if the economy
experiences a shock? y
• Suppose that investment rate increases from s to
s’. ( n + d) k
• This shifts the investment curve from sy to s’y. B
• At the initial steady state level, A, investment per s ¢y
worker exceeds the amount required to keep
capital per worker constant and thus the
A sy
economy experiences capital deepening.
• This process continues until investment per
worker equals depreciation (s’y = (n+)k) at
k
* **
point B. k k
• At B, per capita output is higher and thus the
per capita income is higher.
Introduction
Economic Growth
The Basic Solow Growth Model: Comparative Statics

• Suppose that population growth rate
increased from n to n’.
• The (n+)k curve rotates leftward to
(n’+)k.
y
• At the initial steady state level, A,
investment per worker is no longer (n ¢ + d ) k
enough to keep the capital per worker (n + d) k
B A
constant as the population is growing. sy
• Therefore, the capital per worker starts
to fall until it reaches a new steady state
level at B.
• At the new steady state level, the k
** *
economy is characterized by low capital k k
per worker (k**), and as a result lower
per capita output.
Introduction
Economic Growth
Economic Growth
• In the simple Solow model, at the steady state level, output

grows at the same rate of population and as a result there is no
growth in per capita output.
• Per capita income grows only until a new steady state is
reached.
• That is, per capita income slows down following the slowdown
of capital per worker.
&
• Consider the equation: k = sk a - 1 - ( n + d)
k
• Since  < 1 and the growth rate of y is proportional to growth
rate of k, then, when k rises, its growth rate eventually declines
and so does output per worker.
Introduction
Economic Growth

Economic Growth
• The higher the level of capital per worker, the
lower the average product of capital y/k due to
diminishing returns to capital accumulation
(<1).
• Thus, in the diagram, the curve sy/k slopes
downward.
• The (n+) line is horizontal. k&k
(n + d)
• The difference between the two lines is the
growth rate of the capital stock per worker.
• This implies that when an economy is far below sk a - 1 = sy / k
the steady state level of k, it grows fast; when
the economy is far above the steady state level k
of k, it declines fast; and at the steady state
level of k per capita income ceases to grow.
Introduction
Economic Growth

Implications
• High level of saving rate (investment rate) implies high level of

per capita income.
• High level of population growth rate implies lower level of per
capita income.
• Thus, country differences in terms of income are attributable to
differences in investment rate and population growth rate.
• The model predicts that there is no growth in per capita income
as these factors affects only levels of per capita income.
• Hence, the model fails to address some of the stylized facts most
importantly the existence of sustained growth in per capita
income.
29
Introduction
Economic Growth
The Solow Growth Model with Technology

• The Solow model uses the Cobb-Douglass production function.

Y = F ( K , A L ) = K a ( A L ) 1- a (25)
Where Y= output, K = capital, L = labor , and A = technology.
• Technology entering the production function this way is called labor
augmenting or Harrod neutral technology. Other options are capital
augmenting or Solow neutral, and Hicks neutral technology.
• In this case, an increase in A over time implies technological progress and
in that sense, a unit of labor is more productive when technological
progress occurs.
• Technology is assumed to be exogenous (like manna from heaven) and
grows at a constant rate over time:
ædA ö
÷
çç ÷
è dt ÷
ø A& (26)
º = g Û A = A0e gt
A A
30
Introduction
Economic Growth
The Solow Growth Model with Technology: The Production Function
• The production function can be expressed in terms of

effective labor by dividing by AL as:
a
Y æK ö÷
= ççç ÷
AL èA L ø÷
(27)
Þ y%= k%a
¶y
>and
¶ 2y
0 < 0
¶k ¶k 2
• The last restriction says that there is a diminishing marginal
product of capital.
• That is firms produce more output by hiring in more capital
for each effective worker. But eventually each additional unit
of capital per effective worker brings about less and less
additional output per effective worker.
31
Introduction
Economic Growth
• The capital accumulation equation is given by:

K&= sY - dK (28)
• It can be expressed in terms of effective labor:

k%= K / A L (29)
• By using the logarithm and total differential and noting that

K&= sY - , dwe
K have:
&
k = sy - (n + d + g ) k%
% (30)
32
Introduction
Economic Growth
The Steady State

&
• At the steady state k%= sk%a - ( n + g + .dUpon
)k%= 0rearrangement and
substitutions, we have the following steady state values of capital per
effective labor and output1per effective labor, respectively:
æ s ö1- a
÷ (31)
%
* ç
k = ç ÷
çè( d + n + g ) ÷
÷
ø
æ s
a
ö÷( 1- a ) (32)
y% = çç
*
÷
çèd + n + g ø÷
Y y
• But y%= =. Thus, per capita output is given by:
AL A
a
æ ö (33)
* ç s ÷
( 1- a )
y t = At ç ÷
çèd + n + g ÷
ø
33
Introduction
Economic Growth
The Solow Growth Model with Technology: The Steady State

• From the equation, we can infer that over time, a steady state level
of per capita output depends on technology.
• Thus, the level of output per worker depends on technology,
investment rate, and population growth rate.
• Sustainable growth in output per worker is, however, determined
by technology.
• At the steady state level, capital, output, consumption, and
population grow at a constant rate of technological change and the
situation is called a balanced growth path.
• Changes in population growth rate and investment rate affect the
level of long-run per capita output but do not affect the long-run
growth rate of per capita output.
34
Introduction
Economic Growth
• Suppose an economy is at a
steady state level with
investment rate s. ( n + d + g )k%
• Suppose further that
investment rate increases y%¢ = s ¢k%
permanently to s’. y%= sk%
• At k%, *investment exceeds the
amount required to keep the
capital per effective labor k%
k%* k%**
constant.
• Thus, k % starts to rise.
Introduction
Economic Growth
• To see the transition ( n + d + g )k%

dynamics, consider the
equation: B y%¢ = s ¢k%
&
k% A y%= sk%
= sy%a - 1 - ( n + g (34)
+ d)
k%
• This can be transformed k%
into the second panel. &/ k%
k%
• At a steady -state, capital
per worker k, output per
worker grow at a rate of g. n + d+ g
• Between A and B, per capita sk%a - 1
s ¢k%a - 1
income grows at a rate

greater than g due to a k%* k%** k%
change in investment.
Introduction
Economic Growth

• The impact of rise of investment rate on consumption depends
on the relative magnitude of the marginal product of capital
and the term (n+g+). This is derived from the so-called
golden rule level of capital.
• The golden rule level of capital argues that the level of
optimum capital stock should be the one which maximizes
consumption and saving could be set accordingly.
• Steady state level of consumption is given by:
* * * (35)
c = y - sy *
• But at a steady-state, sy = (n + d + g ) k *.
• We also note that: sy* = f.(k * )
• Thus:
c * = f ( k *) - ( n + d + g )k * (36)
37
Introduction
Economic Growth

• At the maximum level of consumption, we have:
dc * df ( k *) d ( n + d + g )k *
= - = 0
dk dk dk
(37)
Þ MPK = n + d + g or MP K - d = n + g
• At the golden rule level of consumption or capital, marginal product
of capital net of depreciation should be equal to population growth
rate plus rate of growth of technology.
• The implication is that „if we do not provide less to future generations
than to ourselves, then the maximum amout of consumption should be
the golden rule level.
• At the golden rule levels, marginal change in s has no impact on
consumption and the latter is at its maximum possible.
• An economy that over saves (above sgold ) is called dynamically
inefficient.
38
Rise in saving rate

t
t0
Rate of capital per
k&
%
effective worker
t
t0
k
Level of capital per
effective worker t
t0
Per capita income growth g

t
t0
Level of per capita income

t
t0
Level of per capita c
?
consumption t
t0
1
Introduction
Economic Growth
Implications of the Solow Model
• Policy changes can have level effects and hence
permanent policy changes can permanently change level
of per capita output.
• Policy changes increases growth rates of per capita
output temporarily (between two steady state levels), thus
with no long-run effects.
• Long-run growth in per capita income is determined by
exogenous technology.
• Convergence: a poor country whose economy is far below
steady state level tends to grow faster than rich countries
whose economy is at a steady state.
40
Introduction
Economic Growth
Convergence
• Convergence is implied by the assumption of diminishing
returns to capital in that economies that have less capital per
worker relative to their long-run level of capital per worker tend
to enjoy higher return to capital thus grow faster.
• Convergence regardless of initial conditions of a countries’
economy is called absolute convergence.
• Convergence could be conditional because steady-state levels of
per capita income and capital per worker depend on country
specific conditions, in particular, saving rates, population
growth rate, and the position of the production function. This is
called conditional convergence.
41
Introduction
Economic Growth
Growth Accounting
• Given factors of production labor, capital, and technology,
growth in output can be decomposed into these factors.
• Consider the production function with Hicks-neutral
productivity parameter, B:
Y = BK a L 1- a (38)
• Taking the logs, and then the derivative. we have:
Y& K& L& B&
= a + ( 1(39)
- a ) +
Y K L B
• This equation says that growth in output is equal to the sum of
the weighted average growth rate of each factor (capital,
labor, and technology).
• The term is referred to as total factor productivity growth or
multifactor productivity growth.
42
Introduction
Economic Growth
Growth Accounting
• In practice, economists determine the share of capital and
labor in output growth and calculate the share as a residual.
• Due to this, the term is usually called “residual” or “Solow’s
residual”.
• While the term may contain the impact of other factors, it is

usually associated with technological change. Sometimes, it is
referred to as “measure of our ignorance”.
43
Introduction
Economic Growth > The Endogenous Growth Models
Introduction
• In the neoclasical growth model, technology is central in
explaining growth differences across countries. But it
remained unmodeled.
• The model has also failed to address one of the stylized
facts namely there exists a sustained rise in growth of per
capita income. That is, growth in per capita income need
not be constant over time.
• The endogenous growth theory or the new growth theory
basically focuses on endogenizing technology.
• There are two strands in the process of attempting to
endogenize technology:
1. Redefining capital
2. A Theory of X

44
Introduction
The AK Model: Redefining Capital

• Capital is redefined by accounting for human capital and
externalities.
• Central in the AK model is the absence of diminishing
returns to capital (linearity of the models).
• Under this assumption, it is possible to sustain growth
without exogenous technology while the assumption of
competitive market is maintained. The important
implication of the AK models is that policy can affect long-
run growth.
• Given the production function:
Y = AK a L1- a (40)
• Let =1, and labor is normalized to 1 so that we have:
Y = AK (41)
45
Introduction

• The capital accumulation equation is given by:
K&= sY - dK (42)
• Assume that variables are in per capita terms (note that
labor is normalized to unity). Combining Equations (41)
and (42):
K&= s( AK ) - dK (43)
K&
Þ = sA - d
K
• Taking the logarithm of the production function and
applying derivatives:
Y& A& K&
= +
Y A K (44)
A&
Þ gY = + sA - d
A
46
Introduction

A&
• Assume that =. 0Then,
A
gY = sA - d (45)
• The last equation says growth can be sustained even without

exogenous technology.
• That is, gY is an increasing function of s.
• Policy can affect growth permanently by affecting s.
47
Introduction
Externalities
• Romer(1986) argued that capital could be reinterpreted as a

combination of physical capital and of the outcome of R&D.
• Thus, capital is not only machinery, equipment and buildings but
includes blueprints and ideas which use to produce new goods.
• Some of the capitals generate externalities to other firms so that
they can learn how to produce new products or how to improve
them.
• Individuals cannot be compensated for accumulating knowledge in
the perfectly competitive market setting.
• If the accumulation of knowledge is itself an accidental by-product
of other activity in the economy, it may still occur. The
accumulation of knowledge can occur because of an externality.
48
Introduction
The AK Model: Externality

• Consider a production function for individual firm:
Y = BK a L 1- a (46)
• There are constant returns in labor and capital. Hence, if B is

accumulated endogenously, production is characterized by increasing
returns.
• But suppose an individual firm takes the level of B as given.
• In reality the accumulation of capital generates new knowledge about
production in the economy as a whole.
• Suppose
B =that:
A K 1- a
(47)
where A is some constant.
• That is, an accident by-product of the accumulation of capital by
firms in the economy is the improvement of the technology that firms
use to produce.
49
Introduction
The AK Model: Externality

• An individual firm does not recognize this effect when it
accumulates capital because it is small in the economy.
• This is the sense technology is external to the firm.
• Firms do not accumulate capital because they know it
improves technology but because it is important input into
production.
• Capital is paid its private marginal product. However, it just
so happens that the accumulation of capital provides an
extraordinary useful and unexpected benefit to the rest of
the economy: It results in a new knowledge.
• Combining the last two equations and normalizing labor to
unity, we have
Y = AK (48)
50
Introduction

Human Capital
• Lucas (1988) proposed a different redefinition of capital whereby
growth can be sustained without exogenous technology.
• He introduced accumulation of human capital along with physical
capital where investment is allotted for the accumulation of both
factors (human and physical capital).
• Consider the production function:
Y = BK a ( HL)1- a (49)
where H is human capital per person.
• Human capital evolves according to:
H&= (1- u ) H (50)
where u is time spent working and (1-u) is time spent accumulating
skill.
51
Introduction

Human Capital
• It works just like the Solow model where A is represented by

human capital and g = 1 - u .
• Thus a policy that leads to a permanent increase in the time
individuals spend obtaining skills generates a permanent
increase in the growth of output per worker.
• Taking the marginal product of capital and human capital and
equating them (the two equals at the steady state), we have:
a a
(1- a ) BK ( NH ) = a BK
a 1- a
( NH )
K (1- a )
Þ =
H a
52
Introduction
The AK Model: Accounting for Human Capital

(a )
• Substituting H= K
1-into
a the production function, we have:
Y = AK (51)
a
a æ
çç a ÷
ö
where A = BN ÷
çè1- a ÷
ø
• Suppose a constant fraction, s, is devoted to total investment.
• To keep K/H constant, the economy needs to devote (1-) of total
investment to the accumulation of capital stock. Then, the steady
state level of growth is given by:
K& (52)
gY = = (1- a )sA - d
K
• Here, s generates growth effects unlike in the Solow model.
• Economic policies can affect the rate of growth either by affecting the
saving rate, s, or by affecting the value of A that is relevant for the
accumulation of capital by private agents say by introducing income
tax.
53
Introduction
The Theory of X
• The models of the AK variant are in the realm of perfect
competition but still failed to systematically endogenize
technology.
• In particular, in the AK model, technology is assumed to be
unintended byproduct of other activities.
• There are attempts to endogenize technology by recognizing
that it is a result of intentional innovation.
• In this case, however, perfectly competitive market
assumtion is not compatible.
• The approaches can be grouped into:
– expanding varieties
– quality ladders, and
– technological transfer.
54
Introduction
The Theory of X
Quality Ladders
• In an economy, old goods are replaced by new ones. Each

new producer gets its fifteen minutes fame before seeing its
product being replaced by a new one.
• Resource is devoted to R&D to improve the quality of a
product. Technology, is thus, generated as a result of such
intentional innovation.
• In models which capture such life cycle aspect of
innovation (Aghion and Howitt, 1992; Grossman and
Helpman, 1991), potential entrants must weight the cost of
improving an existing good against the benefit of being
monopoly power if innovation succeeded.
55
Introduction
The Theory of X
Expanding Varaieties
• Romer (1990) attempted to formally model the way

technology is generated.
• His model assumes that technology is a result of intentional
research activities that targets on generating new
mousetraps in an effort to maximize profit.
• Growth in technology (that determines the sustainable
growth in per capita income) is a function of the rate of
growth of the segment of the labor force which is engaged
in generating new ideas.
56
Introduction
The Theory of X: Expanding Varieties

• Labor L is divided into those who are involved in output production (LY)
and those who are involved in research activities which generate new ideas
(LA).
L = LA + LY
LA = sR L (53)
LY = (1- sR ) L
• Labor force in the research sector grows at a rate of population growth, n.
L&A L&
= = n
LA L (54)
• Production evolves according to:
Y = K a ( A LY ) 1- a (55)
• The production function can be re-written in per capita terms as:
y = k%a (1- s )
1- a
% (56)
R
57
Introduction

• The capital accumulation equation in per capita terms is given by:

& (57)
k%= sK %
y - (n + d + g A ) k%
Ideas and Technology

• For a given level of technology, the production function exhibits constant
returns to scale in labor(LY) and capital.
• Here, A is recognized as an input representing idea. In doing so, increasing
returns to scale is implied.
• Once ideas are invented, no need to double ideas to have output doubled.
Doubling labor and capital more than doubles output due to the non-
rivalrous nature of ideas. That is, ideas generate positive externality.
58
Introduction
Ideas and Technology

• Thus ideas are non-rivalorous which implies increasing returns
to scale, and this in turn implies imperfect competition.
Increasing Imperfect
Ideas Non-rivalerousness
Returns Competition
• That is, firms will not be willing to invest in new ideas unless
the market compensates them for the initial investment on
R&D.
• But profit in the competitive market is zero and the perfectly
competitive market cannot reward them.
59
Introduction

Endogenizing Technology
• How can technology be endogenized?
• Romer (1990) argued that the technology parameter A that we
saw in the neoclassical model to be exogenously determined
represents, in this setting, the stock of knowledge or the
number of ideas that have been invented so far.
• The number of new ideas invented at a given point in time
(additions to the stock of ideas) is equal to the number of
people engaged in discovering new ideas, LA, multiplied by the
rate at which they discover new ideas . d
• That is:
A&= d LlA (58)
where 0<  <1 and  represents degree of externality
(duplication).
60
Introduction
• The rate at which researchers discover new ideas may depend
on the stock of ideas, A:
f
d = dA (59)
• Three cases:
– If  < 0, it implies that obvious ideas are discovered first and further
discovery is harder;
– If  > 0, it implies that productivity of a research increases with the
stock of ideas discovered so far (standing on shoulder effect);
– If  = 0, it would imply productivity of a research is independent of
stock of knowledge (stepping on toes effect).
61
Introduction
• Combining equations, (58) and (59), we have:
A&= d LAl A f (60)
• Taking the growth rate of the last equation:
ln (61)
g =
A
1- f
• This shows that advancement in technology is a function of the
growth rate of population. That is, it is highly likely to get
brilliant minds that can create new ideas among 10 million
people than among 10 people!
62
Introduction
The Economy at the Steady State

• At a steady-state, capital per effective labor can be derived to
give: 1
%
æ sK
ç
ö
÷
1- a (62)
k=ç ÷
÷ .(1- sR )
÷
çè n + d + g ø
• Substituting this value in the production function (Eq. (55)), we

can solve for per capita income:
y (t ) = k%a .(1- sR ) A(t )
1- a
a
ìï 1 a
ü
ïï æ sK ö
÷
1- a
ïï æ s ö÷ ç (63) (1- sR ) A(t )
(1- sR )ïý (1- sR ) A(t ) = ççè n + d + g ÷
1- a
= íç ç K
÷
1- a
÷
÷
ïï çè n + d + g ø÷
÷ ïï ø
ïî ïþ
63
Introduction

• Equation (60) can be re-arranged to give:
A&
l
d ( sR L) (64)
= gA =
A A1- f
• Assuming  = 1 and =0, we have:
dsR L (65)
A=
gA
• Substituting this last equation for A (Eq. (65)) into the equation of the
steady state level of per capita income (Eq.(63)):
a
æ sK ö÷ 1- a ædsR ö÷
ç
y (t ) = ç ÷
çè n + d + g ø÷
÷
(1- sR )ççç ÷÷÷L(t ) (66)
èg ø
A
64
Introduction
• In this last equation:

a
æ sK ö1- a ædsR ö
y (t ) = çç ÷
÷ (1 - s )ç ÷ ÷L(t )
÷
çè n + d + g ø R ç
çè g ø÷
÷ A
÷
• We notice that unlike in the case of Solow model, labor force has also
positive impact on the steady-state level of per capita income.
• While population growth has negative impact on the level of per
capita income, it has positive impact on growth of per capita income
through its capacity to generate individuals who can conduct
research on ideas.
• In this setting, with the assumption of exogenous population growth,
policy cannot affect long-term growth in per capita income.
65
Introduction
The Theory of X
Technological Transfer
• The Romer (1990) model is exclusively relevant to only advanced

countries. Under this setting, the model does not predict convergence.
The question of convergence can be addressed by introducing
technological transfer.
• Consider a country far from the (world) technology frontier. Agents in
such a country produce output by using intermediate capital inputs xj
according to: h
Yt = L1- a ò x j dj (67)
j= 0
• Number of intermediate capital goods is limited by the skill level h.
h (t )
Kt = ò x dj j
(68)
j= 0
66
Introduction
The Theory of X: Technological Transfer

• Output evolves according to:
1- a
Yt = K a (hL) (69) where h enters as
labor augmenting technology.
• Capital accumulation is represented by:
a
æ sK ö÷
1- a (70)
y (t ) = çç ÷ h(t )
çè n + d + g ø÷
÷
• Transforming Equations (69) and Eq. (70) in per capita terms, the
steady-state level of per capita output is given by:
(71)
K&= sK Y - dK
• The key point here is the way skill h is generated. Skill is defined as
a range of intermediate goods that an individual learns like the use
of hoe, oxen, application of fertilizer, tractor, etc.
67
Introduction
• The individual learns to use advanced capital goods according to:

h&= mey u Ag h1- g (72)
where  = degree of openness to world technology to account for degree of
technology transfer;  = number of years spent in learning new techniques;
A = world technology frontier;  and  are parameters.
• Rearranging Equation (72):
h&
g
æ Ah ö
÷
= me y u çç
h çè h ÷
÷
ø (73)
• The world technology (that of developed countries) grows at a rate and
A&
= g
&
skill accumulation grows at same rate g. Thus, . h= g A
• Equation (73) becomes, h

1
æmeyu ö
÷
g
h(t ) = çç ÷
÷ A(t ) (74)
çè g ÷
ø
68
Introduction

• Substituting Eq. (74) into1Eq.(70), we get:
a
æ sK
ç
ö
1- a
÷ æmey u ÷
çç
ög (75)
y (t ) = ç ÷ ÷ A(t )
çè n + d + g ÷
÷
ø çè g ÷÷
ø
• This says that countries which invest a greater portion of their
income, which have low rate of population growth rate, whose
population spend more time in accumulating skill to be able to
transfer technology from the world pool are richer.
• Sustainable per capita income is still possible due to the world
technology which is invented in developed countries. That is, per
capita income of countries in the world grows at a ‘universal’
rate of technological growth, g.
69
Introduction
• In reality, we know that growth rates in per capita income are

not the same across countries.
• The reason, according to the theory, is simply because
countries differ in initial conditions, that is, their relative
position from the respective steady-state path is not the same.
• In this model, convergence is possible more importantly
because of the fact that poor countries which are very far
from the technology frontier can accelerate by copying the
already available technology (invented by advanced
countries) with no need to invent new ideas.

70
Introduction
More Fundamental Questions

• Why some countries invest more than others?
• Why some countries have low population growth rate while
still others have high population growth rate?
• Why some countries spend little time on research and other
spend more?
• Why some countries invest more on education while others do
not spend much on this venture?
• The answers are found in more fundamental issues like rules

and regulations, institutions that enforce these rules and
regulations, history (aspiration failure), culture.
71

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Macroeconomic Development Policy-I

Zentrum für Entwicklungsforschung (ZEF)

Definition: Measuring Growth

Definition: Measuring Growth

Definition: Growth Decomposition by Sector

Definition: Growth in Per capita GDP

Growth in per capita income (gy) = growth in GDP (gY )– growth in

Stylized Facts of Growth

The Basic Solow Growth Model

The Production Function

• He used the Cobb-Douglass production function.

The Solow Growth Model: The Production Function

The Basic Solow Growth Model: The Production Function

The Basic Solow Growth Model

• From the demand side, assuming a closed economy, output

The Basic Solow Growth Model: The Capital Accumulation Equation

The Basic Solow Growth Model: The Capital Accumulation Equation

The Basic Solow Growth Model: The Capital Accumulation Equation

The Basic Solow Growth Model: The Capital Accumulation Equation

The Basic Solow Growth Model

The Steady State

• So far, we have developed two important equations:

The Basic Solow Growth Model: The Steady State

The Basic Solow Growth Model: The Steady State

The Basic Solow Growth Model: The Steady State

A steady-state is a situation where variables involved grow at a

The Basic Solow Growth Model: The Steady State

The Basic Solow Growth Model: The Steady State

• Substituting this result into the production function, we have

The Basic Solow Growth Model: The Steady State

The Basic Solow Growth Model: Comparative Statics

The Basic Solow Growth Model

• In the simple Solow model, at the steady state level, output

The Basic Solow Growth Model

The Basic Solow Growth Model

• High level of saving rate (investment rate) implies high level of

The Solow Growth Model with Technology

• The Solow model uses the Cobb-Douglass production function.

The Solow Growth Model with Technology: The Production Function

• The production function can be expressed in terms of

The Capital Accumulation Equation

• The capital accumulation equation is given by:

• It can be expressed in terms of effective labor:

• By using the logarithm and total differential and noting that

The Solow Growth Model with Technology

The Steady State

The Solow Growth Model with Technology: The Steady State

• To see the transition ( n + d + g )k%

income grows at a rate

The Solow Growth Model with Technology: The Steady State

The Solow Growth Model with Technology: The Steady State

Rise in saving rate

Per capita income growth g

Level of per capita income

• While the term may contain the impact of other factors, it is

The AK Model: Redefining Capital

The AK Model: Redefining Capital

The AK Model: Redefining Capital

• The last equation says growth can be sustained even without

The AK Model: Redefining Capital

• Romer(1986) argued that capital could be reinterpreted as a

The AK Model: Externality