CarlinSoskice PPT ch08

Carlin
Type author
& Soskice
names here
Macroeconomics: Institutions,
Instability, and the Financial System
Chapter 8:
Growth, Fluctuations
and Innovation
These slides are authored by Hillary Wee,
UCL, Cambridge
© Wendy Carlin and David Soskice, 2015. All rights reserved.

Objectives: Chapter 8
By the end of this chapter, students should understand the

following:
 Proximate sources of growth and the role of capitalism.

 Connecting the 3-equation model and long-run models.
 Useful mathematical tools in understanding growth.
 The Solow model and augmented versions of it.
 Economic convergence and growth accounting.
 Endogenous growth models.
 The Schumpeterian growth model.
Carlin & Soskice: Macroeconomics: Institutions, Instability, and the Financial System
Overview: Chapter 8
Capitalism transforms the world
 1750s: UK Industrial Revolution → rapid growth in living standards
 Rapidly widening gap between UK and China until the late 2000s
Overview: Chapter 8
 No vast difference in living standards across countries perhaps
until the emergence of capitalism
 Starting mid-17th century: England/GB diverged
Overview: Chapter 8
Large difference in growth btw capitalist S.Korea and planned USSR.
But still, there are pre-conditions for a successful market economy:
 1990s: Planning abandoned in USSR → lengthy transitional recession
 Weaker growth in African market economies vs the planned USSR
Overview: Chapter 8
 Planning was important in allowing poor countries to industrialize
(eg. electrification, education)
 Benefits of planning outweigh dampening market incentives in
poor countries.
 Likewise, costs of planning in hampering innovation outweigh its
benefits for already industrialized countries.
Proximate and fundamental sources of growth:

 Proximate/ Immediate sources:
Accumulation of capital (both planning & capitalism succeeded),
Development & diffusion of new technology (capitalism was superior)
 Fundamental sources (what explains capital accumulation and

technological development):
e.g. Geography, culture, institutions.
*Not the focus of this book.
Modelling: Comparing the models
Short- & medium-run macro models and growth theory:

 S/run & M/run vs Solow growth model: Difference in how the
savings rate affects output.
S/run model (Keynesian C function):

↑ Savings → ↓ AD → ↓ Output
(Paradox of thrift)
Note: High savings is not translated
into higher investment
M/run model with a -targeting CB:

↑ Savings → → ↓ → is cut by CB
→ ↑ Investment → .
Solow Model:
 Concave production fn. F(K), savings & depreciation rate and .
Solow model:
↑ Saving rate → ↑ Capital (K) →
↑ Output
Note: Savings are automatically

invested, so no fall in AD from
rise in savings.
Connecting the Solow and 3-equation models:

 Drop the assumption that savings are automatically invested.
3-equation model:
↑ Saving rate → CB understands
the paradox of thrift and that
has increased → CB cuts to
boost investment → Economy
moves from pt. A to Z.
Modelling: Useful tools
Growth concepts and useful tools:
 Annual Growth Rate:
 Log difference method for AGR:
 Compound Annual Growth Rate: ; is no. of periods, is initial
GDP.
 Exponential method for CAGR: for continuous time (▲)
 The rule of 70: Given a constant AGR, the time taken for to double:
 Continuous vs discrete time:
Discrete time rate of change:
Cont. time rate of change:
Discrete time growth rate:
Cont. time growth rate:
Modelling: Useful tools
Relationship between exponential growth and logs:

 Applying a log transformation to (▲), we get:
 So, constant growth rate → Exponential growth due to compounding
Modelling: The Solow Model
Solow Model:
 Cobb-Douglas constant returns to scale (CRS) production function: ; is
capital’s share of income, is labour’s.
 Dividing by , we get the intensive production function:
Diminishing returns to K:
The Average Product of

Capital (APK) is always
larger than the Marginal
Product of Capital (MPK)
 Exogenous growth rate of labour input:
 Growth of capital input: , and investment equals savings .
 Substituting the prod. function into the above eqn’s : **
 Dividing by , we get the growth rate of :
Steady state or balanced growth: Output and capital grow at a constant rate.
 Under no technological progress, this implies .
 Capital- labour ratio is constant at the steady state level: *
 Steady state (SS) growth requires:
 Rearranging, steady state capital- output ratio: * (∎)
 At SS: and grow at the same rate as ; No growth in per capita ().
 * is higher the higher is and the lower is and .
Steady state growth of output:
 Downward sloping growth in capital : APK is decreasing in .
 lies between and : Output is weighted average of and .
 In the steady state, all curves intersect since .
Steady state growth path:

 From slide 13**,
 Dividing by and rearranging yields: (┼)
 Since , subtracting this from (┼) yields:
 Multiplying by , we get the Fundamental Solow Eqn
of Motion: , this shows how capital per worker
varies over time
 The first term shows the extent to which
investment is adding to .
 The second term shows how much
investment is needed to offset depreciation ()
and to equip additions to the labour force ().
 Under no savings (), capital per capita will be
falling under pressures of depreciation and
population growth (, → ).
The Solow diagram:
 If , increases (see the Fundamental Eq. of Motion).
 The intersection point of and gives the steady state, at which * ( and
stay constant).
Consumption per head in the SS is given by:

* **
*
Also, applying the SS condition of to the Fund. Eq. of Motion yields explicit SS
values of * and *:
* ;
*
Solow model results:

 Higher savings (and inv.) rate raises output per capita, but not necessarily
welfare.
 Marked rise in China’s investment share vs decline in the rest of the world.
 Much discussion about the need to reduce China’s investment share- Why?
 Preferable measure of welfare: Consumption per capita ()

 Golden rule savings rate (): Savings rate that maximizes welfare.
 Graphically: Consumption per worker (gap between production and savings)

is maximized at .
Note:
Increasing above
reduces consumption per
head and hence welfare.
↑ Higher welfare
 Under perfect competition, slope of the tangent to the

production function (the marginal product of capital) is
.
 Fig 8.11: is maximized when , i.e. when ; The function
goes through this point.
 ∴ Condition for : ; .
 Rearranging (∎) from slide 13,
 So and
 At the golden rule, total savings () equal
total profits (), hence total wages equal
total consumption.
 For the Cobb-Douglas production function,
, so .
Application: Reduction in Savings
Reduction in savings rate:
• falls to :
• curve shifts downwards.
• Economy slowly adjusts from old SS () to new SS (
• Transitional dynamics:
• curve shifts downwards.
• and falls immediately
• As the economy converges to the new SS, and rise
back to the SS value of
• is permanently lower but might increase if .
The Solow model and cross-country differences in GDP p.c.
• From model results: * ,
• increases in savings and decreases in
population growth.
• But weak relationship expressed in data.
• The model cannot explain large variations in
living standards we see today.
Modelling: Solow: Convergence
Convergence between rich and poor countries

 Absolute convergence: Poor countries grow
faster and their GDP p.c. catches up with rich
countries.
Use Fund. Solow Law of Motion:
and divide by :
.
Note that in the SS, so .
Diagram: Balance growth paths for rich cty (A) and

poor cty (B): .
Poor cty may boost by increasing → jumps

immediately → Economy gradually transits to pt. A.
Fig 8.15a: No evidence for absolute convergence

 We should observe a negative relation under absolute convergence.
Convergence between rich and poor countries

 Conditional convergence: Countries converge
to unique steady states; Similar countries share
steady states close to one another.
Production functions does not differ btw. rich (more
efficient) and poor.
Intensive production fn. for rich is and for poor is .
Even with the same savings rate, for a given will still
differ.
Key feature of cc: it is the distance away from a
country’s steady state that dictates the speed of
output per capita growth.
∴ Countries with similar steady states will converge,

fundamentally diff. economies will not (poor countries
may have inferior production function)
Fig 8.15b: Some evidence for conditional convergence

 Amongst OECD economies in the ‘golden age’ (1950-1973)
Modelling: Augmented Solow Model
Solow Model with Human Capital
 Fig 8.16: Richer countries have higher educational attainment
 Augmented production function: ; : educational attainment.

 Solving for the steady state level of output per capita (slide 13): ,
so countries with higher levels of educ. attainment will have higher levels of
SS output p.c.
 Potentially explains the persistent gap in living standards btw poor & rich.
Technological progress in the Solow model
 Production fn: ; , : rate of tech progress
 The Balanced growth path is now: and .
 To reconcile this with the standard Solow model, utilize “efficiency units”:
and , & are efficiency units of output & capital.
 The fundamental law of motion is now:
 Thus the steady state refers to no change in capital per efficiency unit ()
 Under , the SS levels of and are: and
 Multiplying by , the SS value of output per worker is:
 is: (1) increasing in the level of technological development and savings rate;
(2) decreasing in the population growth rate and depreciation rate.
The Solow model with technological progress

 Higher and mean higher , but only a higher can raise the growth of .
 Fig 8.17: In terms of efficiency units; ↑ → ↑ growth of (higher growth path).
Modelling: Growth Accounting
Growth accounting: measuring the impact of technology

 Growth accounting: Solow’s method of calculating TFP growth*
 Log-differentiate , and we get
 Rearranging in per capita terms: *
 Widely criticized way of measuring but it can be useful in quantifying the

contribution to growth of various production factors (labour, capital, TFP).
 Interesting findings regarding TFP (p291-292):

• 1980-1995: TFP growth in the EU > US, but reversed after 1995.
• Contribution of the knowledge economy (ICT capital and labour

composition) in the US overtook that in the EU.
• Most of the US-EU difference came from the unexplained ‘residual TFP’.
Modelling: The Romer Model
Endogenous growth: the Romer model

 In the Solow model :
• Policies to boost long-run GDP p.c. is limited by diminishing factor returns.
• Long-run output growth comes from exogenous technological progress.
 Endogenous growth models make it possible for policy to affect SS growth
→ Requires a production function with constant (not diminishing) factor returns.
Endogenous growth model:

E.g. No diminishing returns to K
When , depreciation just offsets
savings so capital stays
constant.
If the savings rate is increased
to , capital stock and output
grows without limit.
Modelling: The Romer Model
The Romer model

 Production function: and , with 2 kinds of labour:
“ : labour producing final goods; : labour producing ideas (R&D) ”
 Under , there are constant returns to the accumulation of ideas → source of

endogenous growth.
 For , dividing by yields the growth rate of ideas: .
 Since the SS growth rate is , the SS growth rate for the Romer model
increases with the no. of people employed in R&D ().
 Solow vs Romer model:

• Solow: The increase in the rate of tech progress () is exogenous.
• Romer: A policy which increases can increase productivity growth.
Modelling: Schumpeterian Growth
Schumpeterian growth: the Aghion-Howitt model

 Creative destruction process involving rent-seeking entrepreneurs.
 ‘Creation’: Entrepreneurs innovate for temporary profit gains
 ‘Destruction’: Old technologies or products become obsolete due to innovation
 Requires that: (1) Innovation cannot be immediately copied (e.g. with patents);
(2) Institutions prevent governments from capturing rents from innovation.
Linking the Solow model to the Schumpeterian model:

 Solow element: ↑ tech progress () → less needed to equip labour → ↓
 Downward sloping Solow steady state relation between and .
 Schumpeterian element: ↑ → ↑ expected returns of innovation → so ↑
 Upward-sloping Schumpeter relationship between and .
Modelling: Schumpeterian Growth
Linking the Solow model to the Schumpeterian model:
 Under the Solow and Schumpeterian relations, the SS growth path is
characterized by the intersection of the two relationships (pt. Z, ).
Application: Raising Productivity Growth
Policies to raise long-run productivity growth

1. Increase savings rate (A → C): Rightward shift in Solow line (for a given , ↑)
2. Improvement in expected returns to innovation, R&D (A → B): Upward shift in
Schumpeter line (for a given , ↑)
Modelling: The Aghion-Howitt Model
Creative destruction, competition and Schumpeterian growth

 The Aghion-Howitt model explains 2 opposite effects of competition on
innovation: (1) Too much competition → ↓ Innovation rent → ↓ Growth
(2) Increased competition → ↑ Rivalry → ↑ Innovation → ↑ Growth
Inverse U-shaped:
Low competition sectors:
More rivalry stimulates
patenting
High competition sectors:

More competition causes
innovation to fall.
Modelling: The Aghion-Howitt Model
 A-H Modelling: 3 sectors differing by innovation possibilities:
1. Frontier sector: Large innovations possible → able to charge
monopoly prices → more competition boosts innovation.
2. 1-step behind: Modest innovations possible → unable to charge
monopoly prices → non-innovating firms not driven out of
business → more competition dampens innovation.
3. 2-steps behind: Innovation spillovers from 1-step behind sectors
→ No incentive to innovate
 Frontier sector = Low competition sectors, and vice versa.
 Schumpeterian growth and business cycle fluctuations:
• Further reason for active counter-cyclical policy: Mitigate fall in
innovation by easing firm’s credit constraints during recessions.
• Policy should promote micro volatility (creative destruction
process) but control macro volatility.
Summary: Chapter 8
 Proximate factors of growth: Factor accumulation and tech. progress.
 Capitalism played a successful role in mobilizing capital for production

and providing incentives for tech. innovation.
 The Solow model shows how capital accumulation boosts long run .
 Solow: Diminishing returns to → Policy limitations in boosting growth.
 Endogenous growth models: Mechanisms offsetting diminishing returns

→ e.g. R&D or knowledge spillovers → Policy can affect l/run growth.
 The Schumpeterian model showcases the ‘creative destruction’

process which can also explain technological progress.

CarlinSoskice PPT ch08

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Carlin

© Wendy Carlin and David Soskice, 2015. All rights reserved.

By the end of this chapter, students should understand the

 Proximate sources of growth and the role of capitalism.

Proximate and fundamental sources of growth:

 Fundamental sources (what explains capital accumulation and

Short- & medium-run macro models and growth theory:

S/run model (Keynesian C function):

M/run model with a -targeting CB:

Note: Savings are automatically

Connecting the Solow and 3-equation models:

Relationship between exponential growth and logs:

The Average Product of

 Rearranging, steady state capital- output ratio: * (∎)

Steady state growth path:

Consumption per head in the SS is given by:

Solow model results:

 Preferable measure of welfare: Consumption per capita ()

 Graphically: Consumption per worker (gap between production and savings)

 Under perfect competition, slope of the tangent to the

Reduction in savings rate:

The Solow model and cross-country differences in GDP p.c.

Convergence between rich and poor countries

Note that in the SS, so .

Diagram: Balance growth paths for rich cty (A) and

Poor cty may boost by increasing → jumps

Fig 8.15a: No evidence for absolute convergence

Convergence between rich and poor countries

∴ Countries with similar steady states will converge,

Fig 8.15b: Some evidence for conditional convergence

 Augmented production function: ; : educational attainment.

The Solow model with technological progress

Growth accounting: measuring the impact of technology

 Log-differentiate , and we get

 Rearranging in per capita terms: *

 Widely criticized way of measuring but it can be useful in quantifying the

 Interesting findings regarding TFP (p291-292):

• Contribution of the knowledge economy (ICT capital and labour

Endogenous growth: the Romer model

Endogenous growth model:

The Romer model

 Under , there are constant returns to the accumulation of ideas → source of

 For , dividing by yields the growth rate of ideas: .

 Solow vs Romer model:

Schumpeterian growth: the Aghion-Howitt model

 ‘Creation’: Entrepreneurs innovate for temporary profit gains

 ‘Destruction’: Old technologies or products become obsolete due to innovation

Linking the Solow model to the Schumpeterian model:

 Downward sloping Solow steady state relation between and .

 Schumpeterian element: ↑ → ↑ expected returns of innovation → so ↑

 Upward-sloping Schumpeter relationship between and .

Policies to raise long-run productivity growth

Creative destruction, competition and Schumpeterian growth

High competition sectors:

 Proximate factors of growth: Factor accumulation and tech. progress.

 Capitalism played a successful role in mobilizing capital for production

 Solow: Diminishing returns to → Policy limitations in boosting growth.

 Endogenous growth models: Mechanisms offsetting diminishing returns

 The Schumpeterian model showcases the ‘creative destruction’

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