 The Sources of Economic Growth: The Growth

Accounting Equation

 Long-Run Growth: The Solow Model

 Endogenous Growth Theory: The AK model

 Government Policies to Raise Long-Run Living

Standards
2
 Economic Growth, or Growth
The increase in GDP per capita of an economy.

3
The annual growth rate of
GDP per capita of the U.S.
economy is mostly positive
but can be negative, as it was
in 2007–2008 and 2008–
2009.

The average annual growth

rate of the U.S. economy
between 1950 and 2017 was
2.0%. The Annual Growth Rate of GDP per Capita in the United
States Between 1950 and 2012 (2005 constant dollars)

4
Exponential growth
A process by which a quantity, like GDP per capita, grows at a constant
proportion or growth rate.

Yt+n = Yt × (1+g)n

Where Yt is the baseline amount in time period t, n is the number of years

in the future, and g is the annual growth rate per period.

Rule of 70:
You can compute the approximate number of years it would take for the
GDP to double at a particular growth rate (g) by using the following rule of
thumb.
70
GDP doubles in: years
g *100
5
An important implication of exponential growth is that small
changes in growth rates lead to large differences in the level of
GDP per capita.

Consider two countries with the same starting level of GDP per
capita, Y1967 =20,000

What would be GDP per capita in 2017 (50 years later) if

country 1 grew at g1=1% and country 2 at g2=2%?

Yt+n = Yt × (1+g)n

if g2=2% : Y2017 =$20,000*(1+0.02)50 = $20,000*2.692= $53,832

if g1=1% : Y2017 =$20,000*(1+0.01)50 = $20,000*1.645= $32,893

6
Average Growth Rates
Define
Y0 = initial value of Yt
Yn = value of Yt after n years
g = average growth rate per year

Then we have that the following is true

Yn = Y0 (1+g)n

And g is given by
g = {(Yn/Y0)1/n – 1 } *100

7
 Countries have grown at very different rates over long spans of time
 Understanding why growth differs across countries and over time is a
fundamental question in economics.

Richest and Poorest Economies

Real GDP per Capita Growth rate
1960 2010 Per year (%)
Luxembourg 17,601 75,589 2.91
Singapore 4,383 55,862 5.22
Norway 12,524 50,488 2.79
United States 15,398 41,365 2.00
Austria 15,256 41,114 1.98
Central African Rep. 968 589 –0.99
Niger 861 522 –1.00
Burundi 344 397 0.29
Zimbabwe 285 320 0.23
Dem. Rep. of Congo 696 241 -2.10
8
What about the implied average growth rates for all countries?

Average Growth Rates of GDP per Capita from 1960 to 2010

(PPP-adjusted 2005 constant dollars)
9
• Y = A F(K,N) (production function with constant returns to scale). (6.1)
• 𝑌 = 𝐴𝐾 𝛼𝐾 𝑁 𝛼𝑁
• 𝐿𝑛𝑌 = 𝐿𝑛𝐴 + 𝛼𝐾𝐿𝑛𝐾 + 𝛼𝐾𝐿𝑛𝑁

• The α terms are the elasticities of output with respect to capital and
labor, their share in total output

• GDP Growth Rate = ΔY/Y

• Growth accounting equation:

ΔY/Y = ΔA/A + α K ΔK/K + α N ΔN/N

• Output, in a country grows from:

• Growth in TFP (entrepreneurial ability, education, roads, technology, etc.)
• Growth in Capital (machines, equipment, plants).
• Growth in Hours (workforce, population, labor participation, etc).
10
• New invention allows firms to produce more for given K and N

ΔY/Y =ΔA/A
A rise of 10% in A raises output by 10%

• Firm’s investment increases capital stock for given A and N

ΔY/Y = α K ΔK/K
A rise of 10% in K raises output by α K times 10%

• Labor increases for example because of an increase in pop. for given A and K

ΔY/Y = α N ΔN/N
A rise of 10% in N raises output by α N times 10%

Both αK and α N are less than 1 due to diminishing marginal productivity

11
Four steps in breaking output growth into its causes (productivity
growth, capital input growth, labor input growth)

1. Measure ΔY/Y , ΔK/K and ΔN/N from data, adjusting for quality.

2. Pick the right Production Function

US Production function : Y = A K.3 N .7

ΔY/Y = ΔA/A + .3 ΔK/K + .7 ΔN/N

3. Calculate the contributions of K and N as 0.3 ΔK/K and 0.7 ΔN/N,
respectively

3. Calculate productivity growth as residual

ΔA/A= ΔY/Y - .3 ΔK/K - .7 ΔN/N

12
13
14
 We also care about growth in Y/N (per capita output = labor productivity).

ΔY/Y = ΔA/A + .3 ΔK/K + .7 ΔN/N

Subtracting ΔN/N on both sides we get:

(ΔY/Y - ΔN/N) = ΔA/A + .3 (ΔK/K - ΔN/N)

Alternatively, from Constant Returns to Scale we get

Y = A F(K,N) = Y/N=AF(K/N,1)

Thus, we can decompose labor productivity growth into TFP growth and capital
deepening (higher capital per worker)

Δ(Y/N)/(Y/N) = ΔA/A + .3Δ(K/N)/(K/N)

15
–

16
–

17
 Labor productivity growth has generally exceeded TFP growth
since 1995
 So, labor productivity growth (Δ(Y/N)/(Y/N)) exceeds TFP
growth (ΔA/A ) because of faster growth of capital relative to
growth of labor (.3Δ(K/N)/(K/N))
 Information and Communications Technology may have been a
prime reason.
 Similar growth in productivity experienced in past
 Steam power, railroads, telegraph in late 1800s
 Electrification of factories after WWI
 Transistor after WWII

 Can sustained growth be driven by capital deepening, hence

by Investment?
 We need to use a model to understand what drives growth in
the long run. 18
• Model by Robert Solow (MIT Nobel laureate)

• Basic framework to clarify the link between capital accumulation

and growth

• Two main questions:

1. What are the fundamental factors that affect growth?

What’s the relationship between growth and saving rate, population

growth rate, and rate of technical progress?

2. How does economic growth evolve over time?

Will it speed up, slow down, or stabilize?
19
• Setup of the Solow model

• Assume:
• proportion of the population of working age is fixed.

Growth rate of population = growth rate of workers.

n = growth rate of N= ΔN/N

• Define:
Yt = output produced at time t
Kt = capital stock at time t
It = gross investment at time t
Ct= consumption at time t

• Assume no Government (G=0) and no Foreign Sector (NX=0):

Yt = Ct + It
C t = Y t - It (6.4)
20
• Define per-worker variables:

yt = Yt / Nt = output per worker at timet

kt = Kt / Nt = capital stock per worker at time t

This is also called the capital labor ratio.

ct= Ct / Nt = consumption per worker at time t

• Define the per-worker production function (assume for now

no productivity growth A=1):

yt = F(Nt ,Kt) / Nt = F(1 ,kt) = f(kt) (6.5)

21
1. As kt increases yt increases (the curve is upward-sloping)

2. As kt increases the marginal increase in production per worker decreases (the

curve becomes flatter as kt increases)
22
• Steady State

• The economy reaches a steady state (SS) when output per

worker (y), consumption per worker (c), and capital per
worker (k) are constant (do not change over time)

• Because K/N is constant in Steady State, then K must grow at

the rate n:

Kt+1 = Kt + nKt

• Recall the equation for the accumulation of physical capital

Kt+1 = Kt –δKt+It
It = Kt+1-Kt +δKt

• Then in Steady State it must be that:

It = (n+δ)*Kt (6.6) 23
• Using equation (6.4), steady state consumption is then

Ct = Yt - (n+δ)*Kt (6.7)
• Dividing both sides by Nt, steady state consumption per-
worker is
c = f(k)- (n+δ)*k (6.8)

• An increase in the steady state level of capital-labor ratio k

has two opposite effects on steady state consumption per
worker:

1. Increases the amount of output each worker can

produce f(k) and hence increases c

2. Increases the amount of goods that must be devoted to

investment and hence decreases c
24
• Two opposite effects of an increase of SS k on consumption per worker

• For low levels of k, as k increases, consumption per worker increases

• For high levels of k, as k increases, consumption per worker decreases

• kG = Golden Rule capital-labor ratio = level of capital-labor ratio that

maximizes consumption per worker in steady state

• kmax = the maximum possible level of capital-labor ration that leaves

zero consumption per worker!

• Policymakers may try to improve the long-run living standard by policies

aimed to increase the capital-labor ratio, when capital is not too high

• In OECD countries, the capital-labor ration is below the Golden Rule level.
25
INCREASING K WILL
INCREASE C UP TO A POINT

THIS IS KG IN THE FIGURE, THE

GOLDEN RULE CAPITAL-
LABOR RATIO

FOR K BEYOND THIS POINT, C

WILL DECLINE

BUT WE ASSUME
HENCEFORTH THAT K IS LESS
THAN KG, SO C ALWAYS RISES
AS K RISES

26
C is getting smaller as k increases to k1
Output is used to maintain an overly-large capital stock
Output and investment per worker

(n+δ)kt
f(k )

I
k0 k1 k

27
 C is getting smaller as k decreases to k2
 Capital is too low to produce sufficient output
Output and investment per worker

(n+δ)kt
f(k )

I
k2 k0 k

28
• Saving

• Additional simplifying assumption: people save a fixed

proportion of their current income (ignore some
variables that may affect saving, as interest rate)

• St = national saving and s = saving rate assumed to be

constant over time. Then

St = sYt (6.9)

• At any point in time national saving must be equal to

national investment. Hence in stady state:

sYt = (n + δ) Kt (6.10)

29
  Finding the Steady State

 Dividing by Nt the previous equation we get that in steady state:

sf(k) = (n + δ) k (6.11)

 That is, in steady state per worker investment have to be

exactly equal to the investment needed to keep k constant

 This equation gives us the steady state level k*

 From that, we can determine the steady state levels of output

and consumption:
y* = f(k*)
c* = f(k*) – (n + δ) k*
 Recall that empirically k* < kG 30
 (n+δ)kt
f(kt)
yt
sf(kt)
c*
sf(k*)

k* kt

Finding steady state capita -labor ratio, per-worker investment, and

per-worker consumption
31
 (n+δ)kt
f(kt)
yt

sf(kt)

sf(kL)
k
(n+δ)kL Total depreciation

kL k* kt

• If k1 < k* then sf(k1) > (n+δ)k1

• Investment exceeds depreciation;
• Hence k increases! And does so until k = k* .
 (n+δ)kt
yt f(kt)

(n+δ)kH k

sf(kH) sf(kt)
Total depreciation

k* kH kt

• If k2 > k* then sf(k2) < (n+δ)k1

• Depreciation exceeds Investment;
• Hence k decreases! And does so until k = k* .
Assume

𝑌𝑡 = 𝐴𝐾𝑡 𝛼𝐾 𝑁𝑡 𝛼𝑁
Then

With the evolution of capital given by

34
Steady state expressions for capital, consumption, income and
investment per worker.

35
• In the model we have seen so far, the economy must
eventually reach the steady state

• In the steady state, the capital-labor ratio, consumption

per worker and output per worker are constant

• Aggregate capital, aggregate output and aggregate

consumption grow at the rate n (growth rate of the
labor force)

• The fundamental determinants of long-run living

standards
• The saving rate
• Population growth
• Productivity growth

36
• According to Solow model, a higher saving rate implies
higher capital-labor ratio, and hence higher living standards!

• Imagine government implements policies to strengthen the

incentive to save

• One impact, saving are higher than investment needed to keep

k constant

• k start increasing up to a new higher steady state k**

37
• Higher saving rate increases output and capital per worker in
the long run

• Since we assumed that k**<kG, then also consumption per

worker increases in the long run

• BUT in the short run consumption decreases because of higher

saving!

• The government should take into consideration the trade-off

between current and future consumption.

38
39
Effects on steady state

(i) k* ↑
(ii) y* ↑ = ↑f(k*)
(iii) c* ↑ = (1 – s)y*
(iv) i* ↑ = ↑sy*

40
• In many developing countries, high population growth is a
major problem.

• Why? What is the relationship between population growth

and the economic performance of a country?

• According to the Solow model, higher population/labor

force growth is associated with lower steady state capital-
labor ratio (and per worker output!)

• If more people enter the labor force, they need more

investment to get the same per worker level of capital!

• Hence the steady state investment per worker has to

increase and steady state output per worker decreases

41
42
Effects on steady state

(i) k* ↓
(ii) y* ↓ = ↓f(k*)
(iii) c* ↓ = ↓(1 – s)y*
(iv) i* ↓ = ↓sy*

The effects of an increase in the depreciation rate are

the same effects on per worker variables as an
increase in n.
43
In the Solow model as n increases, output per worker
decreases.
However:

1)Aggregate output may increase

– A Country may evaluate also aggregate output for
example for political or military reasons

2)The Solow model also assumes that the proportion of

the population of working age is fixed. But when population
growth changes dramatically this may not be true

– It may be that when population decreases, the

proportion of retirees to working age population
increases
– This may create problems for Social Security or Health
Care 44
• In the Solow model, for given n and s, eventually the economy stops
growing

• However, if productivity keeps increasing, the economy can achieve

sustained growth!

• Higher productivity means you can produce more output with the same
capital- labor ratio!

• Assume that the new production function per worker is Af(k) with A>1.

• This increases the steady state output per worker for two reasons:

1) Productivity improvement directly improves the amount of output

that can be produced at any capital–labor ratio. For given k* steady
state output is higher because Af(k*)> f(k*)
2) The increase in output per worker increases the supply
of saving, causing the steady state capital-labor ratio k* to rise.
45
46
Effects on steady state

(i) k* ↑
(ii) y* ↑ = ↑Af(k*)
(iii) c* ↑ = ↑(1 – s)y*
(iv) i* ↑ = ↑ sy*

47
• Can consumption per worker grow indefinitely?

• Recall labor productivity growth: Δ(Y/N)/(Y/N) = ΔA/A + .3Δ(K/N)/(K/N)

• From the Solow model k=K/N is determined by sf(k) = (n + δ) k

• Hence, k can keep growing only if:

1) s keeps increasing, BUT the saving rate can’t rise forever, it peaks at 100%.

2)n keeps decreasing over time, BUT the population growth rate can’t fall
forever, there is a limit on how much N can decrease!

• 3) According to the Solow model, the only source of sustained growth

can be productivity growth (ΔA/A) .

• The rate of productivity improvement is the dominant factor

determining how quickly living standards rise in a nation.

48
• The Solow model implies that the only source of long-run growth is
productivity

• However, it does not tell us how productivity is determined

• The Solow model assumes that there is exogenous productivity growth

that leads to long-run growth of output per worker

• Endogenous growth model (or AK model) tries to explain

productivity growth endogenously, that is, within the model

• In such a model productivity growth will be affected by the saving rate

• The model was developed by Paul Romer, an economist at Berkeley

University

49
• For simplicity, assume that the number of workers is now constant
(n=0)

• This implies that the growth rate of output per worker is equal to the
growth rate of aggregate output

• Aggregate production function is now:

Y = AK (6.12)

• Each additional unit of K increase output by A, irrespective on how

much K is in the economy!

• This production function has constant marginal productivity of

capital (No diminishing marginal productivity of capital)

50
• Why marginal productivity of capital may be not diminishing?

• Because of R&D and human capital, that is, knowledge, skills, and
training of the labor force

• As economies accumulate K, they become richer and invest more in

human capital (schooling, training,…) and in R&D.

• Human capital tends to increase in the same proportion

as physical capital

• Increases in capital and output generate increased technical

knowledge, which offsets decline in MPK from having more capital.

• Hence, marginal product of K stays constant.

51
• As in the Solow model, assume that national saving are a constant fraction s of
aggregate output

S = sY=sAK

• Also recall that gross investment = net investment + depreciation

I = Δ K + δK

• Recall that we assume NX=G=0 and hence S=I

• Setting investment equal to saving implies:

sAK = Δ K + δK (6.13)

52
• From the previous equation (dividing both sides by K) we obtain

ΔK/K = sA – δ (6.14)

• Because output is proportional to capital stock (Y=AK) the growth

rate of output has to be equal to the growth rate of capital stock, and
hence

ΔY/Y = sA – δ (6.15)

• In this model, the long run growth rate of output (and output per
worker) depends crucially on the saving rate. Higher saving
stimulate higher investment in human capital and R&D

• This endogenously increases productivity and hence spur growth!

• Government policy to stimulate saving is even more important here.

• This is very different from Solow model, where the long run growth
rate was only affected by productivity.
53
 Policies to affect the saving rate
 If the private market is efficient, the government shouldn’t try to change
the saving rate
 The private market’s saving rate represents its trade-off of present for
future consumption
 But if tax laws or myopia cause an inefficiently low level of saving,
government policy to raise the saving rate may be justified

 How can saving be increased?

 One way is to raise the real interest rate to encourage saving; but the
response of saving to changes in the real interest rate seems to be
small.
 Moving to a Consumption based Tax (rather than income tax)

 Another way is to increase government saving

 The government could reduce the deficit or run a surplus
 But under Ricardian equivalence, tax increases to reduce the deficit
54
won’t affect national saving
 Improving infrastructure
 Infrastructure: highways, bridges, utilities, dams, airports
 Empirical studies suggest a link between infrastructure
and productivity
 U.S. infrastructure spending has declined in the last two
decades

 Would increased infrastructure spending increase

productivity?
 There might be reverse causation: Richer countries with
higher productivity spend more on infrastructure, rather
than vice versa
 Infrastructure investments by government may be
inefficient, since politics, not economic efficiency, is often
the main determinant
55
 Building human capital
 There’s a strong connection between productivity and human capital
 Government can encourage human capital formation through
educational policies, worker training and relocation programs, and
health programs
 Another form of human capital is entrepreneurial skill
 Government could help by removing barriers like red tape

 Encouraging research and development

 Support scientific research
 Fund government research facilities
 Provide grants to researchers
 Contract for particular projects
 Give tax incentives
 Provide support for science education
 Patents and Copyrights
56