Macroeconomics & The Global Economy: Ace Institute of Management Session 9: Economic Growth

Macroeconomics & The Global Economy
Ace Institute of Management
Session 9: Economic Growth

Instructor Rijan Dhakal [email protected] 9851069004
The Solow or Neo Classical Model

A major paradigm by Robert Solow: widely used in policy making benchmark against which most recent growth theories are compared The rate at which the output of the economy grows basically depends on the rate at which the followings grow over time: Capital Stock Factors of Production Labour Force Technological Progress - Production Function
CHAPTER 7
Economic Growth I
slide 1
The Solow Model- Accumulation of Capital Stock in an Economy

How much capital an economy can accumulate depends on:
supply of goods (Output) : depends on
Production function
demand for goods (Input): depends on
Consumption function
CHAPTER 7
Economic Growth I
slide 2
The production function

In aggregate terms: Y = F (K, L ) where
Y = Output K = Capital Stock L = No. of Labour
Assumption: Constant return to scale. So, zY = F (zK, zL ) for any z > 0 Suppose, z = 1/L. Then, Y/L = F (K/L , 1)
Output per worker (Y/L) is the function of capital per worker (K/L) .
CHAPTER 7
Economic Growth I
slide 3

Assume, Y/L = y and K/L = k. Then,
y =
f(k). Ignore 1 as a constant. (i)
Eqn, (i) shows how much extra output a
worker produces given an extra capital (Marginal Product of Capital-MPK).
CHAPTER 7
Economic Growth I
slide 4

Output per worker, y
Note: When capital per worker is high, extra unit of capital produces lower output Vice Versa.
f(k)
1
MPK
Note: this production function exhibits diminishing MPK.
Capital per worker, k

CHAPTER 7
Economic Growth I
slide 5
The Demand for Goods and Services

y = c + i (remember, no G : Two Sector) In per worker terms: Output per worker is divided into consumption per worker and investment per worker
Since people save and consume their income,

If savings rate = s, then, c = (1-s)
So, fraction of the income that people consume is

c = (1-s)y .. Consumption Fn.
CHAPTER 7
Economic Growth I
slide 6
The Demand for Goods and Services

Substituting the value of c in y;
y = (1-s)y + i
i = sy
or
Shows that investment equals saving where

s is the fraction of the output/ income
devoted to investment.
CHAPTER 7
Economic Growth I
slide 7
Basis of Neo-Classical Growth Model

The main building block of the model: production function (Y depends on K, L and the technological progress)
Investment : K
Depreciation : K So, When I > D; K
When I < D; K
When I = D; K- Unchanged (Steady State) Big Question: When does investment exceed depreciation, and when does it fall short of it?
CHAPTER 7
Economic Growth I
slide 8
Basis of Neo-Classical Growth Model

Depreciation: we may safely assume it as a constant (usually shown by 45 degree).
Investment: Can be shown in terms of savings.

Saving is a fixed share of total income. Therefore, savings
and/or investment at different capital stocks can be presented as a part of the total output (Income).
CHAPTER 7
Economic Growth I
slide 9
Graphical representation without Technology
Output Per Worker
Steady State
Capital Per Worker

CHAPTER 7
Economic Growth I
slide 10
Golden Rule level of Capital
The Golden Rule level of capital accumulation is the steady state with the highest level of consumption.
Output Per Worker
C*gold
Steady State
I*gold
k*gold
CHAPTER 7
Capital Per Worker

slide 11
Economic Growth I
The model and increase in the saving rate
Output Per Worker
Capital Per Worker

CHAPTER 7
Economic Growth I
slide 12
The model and increase in population
CHAPTER 7
Economic Growth I
slide 13
Effect of Technological Advancement

Productivity per y worker increases y* Shifts the Production y* functions upward Saving rate shifts upward Capital stock per worker increases New Steady State is formed Output per worker is increased but greater than k
CHAPTER 7
y = f(k) y = f(k) ir = dk i = s' f(k) i = s f(k)
k* k1*
k
slide 14
Economic Growth I
Policy issues: How to increase the saving rate?

Reduce the government budget deficit (or increase the budget surplus).
Increase incentives for private saving. Example: Reduce tax
CHAPTER 7
Economic Growth I
slide 15
Policy issues: Allocating the economys investment

In the Solow model, theres one type of capital.
In the real world, there are many types, which we can divide into three categories: private capital stock public infrastructure human capital: the knowledge and skills that workers acquire through education.
How should we allocate investment among these types?
CHAPTER 7
Economic Growth I
slide 16
Policy issues: Allocating the economys investment

Two viewpoints: 1. Let the market allocate investment to the type with the highest marginal product. 2. Industrial policy by government: Govt should actively encourage investment in capital of certain types or in certain industries, because they may have positive externalities that private investors dont consider.
CHAPTER 7
Economic Growth I
slide 17
Policy issues: Establishing the right institutions

Creating the right institutions is important for ensuring that resources are allocated to their best use. Examples:
Legal institutions, to protect property rights. Capital markets, to help financial capital flow
to the best investment projects.

A corruption-free government, to promote
competition, enforce contracts, etc.

CHAPTER 7
Economic Growth I
slide 18
Policy issues: Encouraging tech. progress

Patent laws: encourage innovation by granting temporary monopolies to inventors of new products. Tax incentives for R&D
Grants to fund basic research at universities Industrial policy: encourages specific industries that are key for rapid tech. progress
CHAPTER 7
Economic Growth I
slide 19
Thank You
CHAPTER 7
Economic Growth I
slide 20

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Macroeconomics & The Global Economy

Ace Institute of Management

Session 9: Economic Growth

The Solow or Neo Classical Model

The Solow Model- Accumulation of Capital Stock in an Economy

demand for goods (Input): depends on

The production function

Y = Output K = Capital Stock L = No. of Labour

The production function

f(k). Ignore 1 as a constant. (i)

Eqn, (i) shows how much extra output a

worker produces given an extra capital (Marginal Product of Capital-MPK).

The production function

Note: this production function exhibits diminishing MPK.

Capital per worker, k

The Demand for Goods and Services

Since people save and consume their income,

So, fraction of the income that people consume is

The Demand for Goods and Services

Shows that investment equals saving where

Basis of Neo-Classical Growth Model

Basis of Neo-Classical Growth Model

Investment: Can be shown in terms of savings.

Graphical representation without Technology

Output Per Worker

Capital Per Worker

Golden Rule level of Capital

Output Per Worker

Capital Per Worker

The model and increase in the saving rate

Output Per Worker

Capital Per Worker

The model and increase in population

Effect of Technological Advancement

y = f(k) y = f(k) ir = dk i = s' f(k) i = s f(k)

Policy issues: How to increase the saving rate?

Increase incentives for private saving. Example: Reduce tax

Policy issues: Allocating the economys investment

Policy issues: Allocating the economys investment

Policy issues: Establishing the right institutions

to the best investment projects.

competition, enforce contracts, etc.

Policy issues: Encouraging tech. progress

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