2a: Economic growth: theory and data

1. 2a: Economic growth: theory and data

2. Growth: big questions, theoretical tools • What does economic growth involve? • Factor accumulation & productivity growth • Changing structure of production, consumption & trade • What makes economies richer? What sustains their growth? • Growth theory • What determines the mix of goods produced, consumed and traded? • Trade theory models for small open economies

3. Southeast Asian experience (1) • East Asia and Pacific region: generally high and consistent growth since 1980s • Especially if we ignore the failures! (Gill & Kharas Table 1.2) • Progress of leading economies from low to middle income status • Poverty alleviation record is strong (G&K Table 1.7) • Inequality rising, but what does this signify? • From high or low base? • Changing structure of production, and urbanization • Relative scarcity of some productive factors – esp. human capital and entrepreneurial abilities • Political economy, and development policy settings

7. The “mechanics” of growth • Why do countries grow at different rates? • Why do rates of growth change over time? • Is there anything that policy makers can do to influence the rate of growth? Aggregate production functions: “parables” or “toys” for understanding aggregate economic growth

8. The aggregate production functionY = F(K,L) Qty of output (Y) A: Linear production function B: Diminishing returns production function YB YA 0 L0 Qty of Variable Input (L)

9. A basic growth model Relate agg. production (Y, measured in $) to capital stock (K), labor force (L), pop. growth (n), savings (S), savings rate (s = S/Y), consumption (C), investment (I), and capital depreciation rate (d) Two-factor production function: Y = F(K, L) (1) (Disposition of income) (Y = C + S) Savings out of income: S = s*Y (2) Savings = investment: S = I (3) Change (Δ) in K stock: ΔK = I – d*K (4) Change in labor force: ΔL = n*L (5) Eq. (1)-(6) can be solved for Y, K, L, I, S, C in terms of s, d and n. Combining (3)-(5) gives: ΔK = s*Y – d*K (6) Using (5) and (6), aggregate output growth depends on net investment & growth of labor force.

10. The Solow growth model • Expressed in intensive form (output per worker, y = Y/L, and capital per worker,k = K/L) • Diminishing returns to k y y = ƒ(k) k • From (6), growth of capital stock per worker : Δk = sy – (n + d)k i.e.Δk rises with savings/worker, declines with pop growth & physical deprctn.

11. y (n+d)k = depreciation y = ƒ(k) = output/worker yH y0 yL sy = savings/worker k kL k0 kH Δk = sy – (n + d)k, so Δk is vertical diffnce sy curve and (n+d)k. • At kL, Δk > 0 and “capital deepening”. Compare kH. • At k0, Δk = 0 with “steady-state” output per worker y0. • “Steady state” implies constant per capita income • Convergence: poorer countries (lower k) will grow faster.

12. Higher savings rate increases per capita income y (n+d)k y = ƒ(k) y1 y0 (s+a)y sy k k0 k1 • Experiment: Increase savings per worker from sy to (s+a)y : At k0, Δk now > 0. New steady state income is y1.

13. Lower population growth raises per capita income y (n+d)k y = ƒ(k) y1 ((n–b)+d)k y0 sy k k0 k1 • How do we represent a reduction in population growth rate? What happens to capital accumulation and steady-state income per worker?

14. More on Solow growth model • Solow: Empirically, technical progress accounts for most economic growth • Think about investments in human capital (education, training) as a form of technical progress that increases the effective labor endowment. • What about natural resources? • Link between Δk and the return on capital • Higher Δk implies higher return on new investment (capital scarcity implies high returns) • Then capital should flow to poorest countries! Can Solow model explain comparative growth experiences?

15. Convergence • Standard Solow model: all countries share same technology, savings rates, etc • Diminishing returns implies lower growth rate of capital per worker at higher levels of k • Implication: absolute convergence • Poorer economies will grow more quickly than richer • Over time, per capita income levels among similar economies will become equal, regardless of initial differences. • Formally: • GDP growth = a*(Base GDP) + b*(K/L growth); a < 0, b > 0

16. Southeast Asian experience (2) • Sources of economic growth in SE Asia • What factors have contributed most to growth? • Labor force growth (“demographic dividend”) • Capital investment (domestic and foreign) • Improvements in effective labor through education, nutrition, etc • Efficiency gains – from trade and specialization; domestic market activation, etc…. • Productivity spillovers and externalities; increasing returns • World Bank: East Asian Miracle (1993), decomposes contribution of some of these to total GDP growth

17. Contributions to growth(per cent/year) Source: East Asian Miracle, 1993 What accounts for the unexplained 13-40%?

18. Is this convergence?

19. Divergent paths in 3 countries Sources: (1950s: Myrdal, Asian Drama; other years: World Bank. Units: 1950s: Indian Rupees; 1978-85: current $US; 2005: PPP$

20. What accounts for divergence within SE Asia?

21. Abstraction vs complexity in economic analysis • Obviously the world does not work exactly as described in Solow’s “parable” • Does this invalidate the use of models? • Economic models abstract from the complexities of real world situations in order to understand underlying mechanisms that are thought (or asserted) to be general • What use is a road map drawn on a 1:1 scale? • Models yield testable implications and their use helps us to define research agendas • Solow model identifies the central mechanism of growth: accumulation of capital per worker