MACROECONOMICS

C H A P T E R
2007 Worth Publishers, all rights reserved
SIXTH EDITION
PowerPoint

Slides by Ron Cronovich

N. GREGORY MANKIW
Economic Growth I:
Capital Accumulation and
Population Growth
7
slide 1
CHAPTER 7 Economic Growth I
In this chapter, you will learn
the closed economy Solow model
how a countrys standard of living depends on its
saving and population growth rates
how to use the Golden Rule to find the optimal
saving rate and capital stock
slide 2
CHAPTER 7 Economic Growth I
Why growth matters
Data on infant mortality rates:
20% in the poorest 1/5 of all countries
0.4% in the richest 1/5
In Pakistan, 85% of people live on less than $2/day.
One-fourth of the poorest countries have had
famines during the past 3 decades.
Poverty is associated with oppression of women
and minorities.
Economic growth raises living standards and
reduces poverty.
Income and poverty in the world
selected countries, 2000
0
10
20
30
40
50
60
70
80
90
100
$0 $5,000 $10,000 $15,000 $20,000
Income per capita in dollars
%

o
f

p
o
p
u
l
a
t
i
o
n

l
i
v
i
n
g

o
n

$
2

p
e
r

d
a
y

o
r

l
e
s
s
Madagascar
India
Bangladesh
Nepal
Botswana
Mexico
Chile
S. Korea
Brazil
Russian
Federation
Thailand
Peru
China
Kenya
slide 4
CHAPTER 7 Economic Growth I
Why growth matters
Anything that effects the long-run rate of economic
growth even by a tiny amount will have huge
effects on living standards in the long run.
1,081.4% 243.7% 85.4%
624.5% 169.2% 64.0%
2.5%
2.0%
100 years 50 years 25 years
percentage increase in
standard of living after
annual
growth rate of
income per
capita
slide 5
CHAPTER 7 Economic Growth I
Why growth matters
If the annual growth rate of U.S. real GDP per
capita had been just one-tenth of one percent
higher during the 1990s, the U.S. would have
generated an additional $496 billion of income
during that decade.
slide 6
CHAPTER 7 Economic Growth I
The lessons of growth theory
can make a positive difference in the lives of
hundreds of millions of people.
These lessons help us
understand why poor
countries are poor
design policies that
can help them grow
learn how our own
growth rate is affected
by shocks and our
governments policies
slide 7
CHAPTER 7 Economic Growth I
The Solow model
due to Robert Solow,
won Nobel Prize for contributions to
the study of economic growth
a major paradigm:
widely used in policy making
benchmark against which most
recent growth theories are compared
looks at the determinants of economic growth
and the standard of living in the long run
slide 8
CHAPTER 7 Economic Growth I
How Solow model is different
from Chapter 3s model
1. K is no longer fixed:
investment causes it to grow,
depreciation causes it to shrink
2. L is no longer fixed:
population growth causes it to grow
3. the consumption function is simpler
slide 9
CHAPTER 7 Economic Growth I
How Solow model is different
from Chapter 3s model
4. no G or T
(only to simplify presentation;
we can still do fiscal policy experiments)
5. cosmetic differences
slide 10
CHAPTER 7 Economic Growth I
The production function
In aggregate terms: Y = F (K, L)
Define: y = Y/L = output per worker
k = K/L = capital per worker
Assume constant returns to scale:
zY = F (zK, zL ) for any z > 0
Pick z = 1/L. Then
Y/L = F (K/L, 1)
y = F (k, 1)
y = f(k) where f(k) = F(k, 1)
slide 11
CHAPTER 7 Economic Growth I
The production function
Output per
worker, y
Capital per
worker, k
f(k)
Note: this production function
exhibits diminishing MPK.
1
MPK = f(k +1) f(k)
slide 12
CHAPTER 7 Economic Growth I
The national income identity
Y = C + I (remember, no G )
In per worker terms:
y = c + i
where c = C/L and i = I /L
slide 13
CHAPTER 7 Economic Growth I
The consumption function
s = the saving rate,
the fraction of income that is saved
(s is an exogenous parameter)
Note: s is the only lowercase variable
that is not equal to
its uppercase version divided by L
Consumption function: c = (1s)y
(per worker)
slide 14
CHAPTER 7 Economic Growth I
Saving and investment
saving (per worker) = y c
= y (1s)y
= sy
National income identity is y = c + i
Rearrange to get: i = y c = sy
(investment = saving, like in chap. 3!)
Using the results above,
i = sy = sf(k)
slide 15
CHAPTER 7 Economic Growth I
Output, consumption, and investment
Output per
worker, y
Capital per
worker, k
f(k)
sf(k)
k
1

y
1

i
1

c
1

slide 16
CHAPTER 7 Economic Growth I
Depreciation
Depreciation
per worker, ok
Capital per
worker, k
ok
o = the rate of depreciation
= the fraction of the capital stock
that wears out each period
1
o
slide 17
CHAPTER 7 Economic Growth I
Capital accumulation
Change in capital stock = investment depreciation
Ak = i ok
Since i = sf(k) , this becomes:
Ak = s f(k) ok
The basic idea: Investment increases the capital
stock, depreciation reduces it.
slide 18
CHAPTER 7 Economic Growth I
The equation of motion for k
The Solow models central equation
Determines behavior of capital over time
which, in turn, determines behavior of
all of the other endogenous variables
because they all depend on k. E.g.,
income per person: y = f(k)
consumption per person: c = (1s) f(k)
Ak = s f(k) ok
slide 19
CHAPTER 7 Economic Growth I
The steady state
If investment is just enough to cover depreciation
[sf(k) = ok ],
then capital per worker will remain constant:
Ak = 0.

This occurs at one value of k, denoted k
*
,
called the steady state capital stock.
Ak = s f(k) ok
slide 20
CHAPTER 7 Economic Growth I
The steady state
Investment
and
depreciation
Capital per
worker, k
sf(k)
ok
k
*

slide 21
CHAPTER 7 Economic Growth I
Moving toward the steady state
Investment
and
depreciation
Capital per
worker, k
sf(k)
ok
k
*

Ak = sf(k) ok
depreciation
Ak
k
1
investment
slide 23
CHAPTER 7 Economic Growth I
Moving toward the steady state
Investment
and
depreciation
Capital per
worker, k
sf(k)
ok
k
*

k
1
Ak = sf(k) ok
Ak
k
2
slide 24
CHAPTER 7 Economic Growth I
Moving toward the steady state
Investment
and
depreciation
Capital per
worker, k
sf(k)
ok
k
*

Ak = sf(k) ok
k
2
investment
depreciation
Ak
slide 26
CHAPTER 7 Economic Growth I
Moving toward the steady state
Investment
and
depreciation
Capital per
worker, k
sf(k)
ok
k
*

Ak = sf(k) ok
k
2
Ak
k
3
slide 27
CHAPTER 7 Economic Growth I
Moving toward the steady state
Investment
and
depreciation
Capital per
worker, k
sf(k)
ok
k
*

Ak = sf(k) ok
k
3
Summary:
As long as k < k
*
,
investment will exceed
depreciation,
and k will continue to
grow toward k
*
.
slide 28
CHAPTER 7 Economic Growth I
Now you try:
Draw the Solow model diagram,
labeling the steady state k
*
.
On the horizontal axis, pick a value greater than k
*
for the economys initial capital stock. Label it k
1
.
Show what happens to k over time.
Does k move toward the steady state or
away from it?
slide 29
CHAPTER 7 Economic Growth I
A numerical example
Production function (aggregate):
= = =
1/2 1/2
( , ) Y F K L K L K L
| |
= =
|
\ .
1/ 2
1/ 2 1/ 2
Y K L K
L L L
= =
1/ 2
( ) y f k k
To derive the per-worker production function,
divide through by L:
Then substitute y = Y/L and k = K/L to get
slide 30
CHAPTER 7 Economic Growth I
A numerical example, cont.
Assume:
s = 0.3
o = 0.1
initial value of k = 4.0
slide 31
CHAPTER 7 Economic Growth I
Approaching the steady state:
A numerical example
Year k y c i ok k
1 4.000 2.000 1.400 0.600 0.400 0.200
2 4.200 2.049 1.435 0.615 0.420 0.195
3 4.395 2.096 1.467 0.629 0.440 0.189
Assumptions: ; 0.3; 0.1; initial 4.0 y k s k o = = = =
4 4.584 2.141 1.499 0.642 0.458 0.184

10 5.602 2.367 1.657 0.710 0.560 0.150

25 7.351 2.706 1.894 0.812 0.732 0.080

100 8.962 2.994 2.096 0.898 0.896 0.002

9.000 3.000 2.100 0.900 0.900 0.000
slide 32
CHAPTER 7 Economic Growth I
Exercise: Solve for the steady state

Continue to assume
s = 0.3, o = 0.1, and y = k
1/2

Use the equation of motion
Ak = s f(k) ok
to solve for the steady-state values of k, y, and c.
slide 33
CHAPTER 7 Economic Growth I
Solution to exercise:

def. of steady state k = 0 A
and y k = = * * 3
eq'n of motion with s f k k k o = = ( *) * 0 A
using assumed values k k = 0.3 * 0.1 *
*
3 *
*
k
k
k
= =
Solve to get: k = * 9
Finally, c s y = = = * (1 ) * 0.7 3 2.1
slide 34
CHAPTER 7 Economic Growth I
An increase in the saving rate
Investment
and
depreciation
k
k
s
1
f(k)
*
k
1
An increase in the saving rate raises investment
causing k to grow toward a new steady state:
s
2
f(k)
*
k
2
slide 35
CHAPTER 7 Economic Growth I
Prediction:
Higher s higher k
*
.
And since y = f(k) ,
higher k
*
higher y
*
.
Thus, the Solow model predicts that countries
with higher rates of saving and investment
will have higher levels of capital and income per
worker in the long run.
slide 36
CHAPTER 7 Economic Growth I
International evidence on investment
rates and income per person
100
1,000
10,000
100,000
0 5 10 15 20 25 30 35
Investment as percentage of output
(average 1960-2000)
Income per
person in
2000
(log scale)
slide 37
CHAPTER 7 Economic Growth I
The Golden Rule: Introduction
Different values of s lead to different steady states.
How do we know which is the best steady state?
The best steady state has the highest possible
consumption per person: c* = (1s) f(k*).
An increase in s
leads to higher k* and y*, which raises c*
reduces consumptions share of income (1s),
which lowers c*.
So, how do we find the s and k* that maximize c*?
slide 38
CHAPTER 7 Economic Growth I
The Golden Rule capital stock
the Golden Rule level of capital,
the steady state value of k
that maximizes consumption.
*
gold
k =
To find it, first express c
*
in terms of k
*
:
c
*
= y
*
i
*

= f (k
*
) i
*

= f (k
*
) ok
*

In the steady state:
i
*
= ok
*

because Ak = 0.
slide 39
CHAPTER 7 Economic Growth I
Then, graph
f(k
*
) and ok
*
,
look for the
point where
the gap between
them is biggest.

The Golden Rule capital stock
steady state
output and
depreciation
steady-state
capital per
worker, k
*

f(k
*
)
o k
*
*
gold
k
*
gold
c
* *
gold gold
i k o =
* *
( )
gold gold
y f k =
slide 40
CHAPTER 7 Economic Growth I
The Golden Rule capital stock
c
*
= f(k
*
) ok
*
is biggest where the
slope of the
production function
equals
the slope of the
depreciation line:
steady-state
capital per
worker, k
*

f(k
*
)
o k
*
*
gold
k
*
gold
c
MPK = o
slide 41
CHAPTER 7 Economic Growth I
The transition to the
Golden Rule steady state
The economy does NOT have a tendency to
move toward the Golden Rule steady state.
Achieving the Golden Rule requires that
policymakers adjust s.
This adjustment leads to a new steady state with
higher consumption.
But what happens to consumption
during the transition to the Golden Rule?
slide 42
CHAPTER 7 Economic Growth I
Starting with too much capital

then increasing c
*

requires a fall in s.
In the transition to
the Golden Rule,
consumption is
higher at all points
in time.
If
gold
k k >
* *
time
t
0
c
i
y
slide 43
CHAPTER 7 Economic Growth I
Starting with too little capital

then increasing c
*

requires an
increase in s.
Future generations
enjoy higher
consumption,
but the current
one experiences
an initial drop
in consumption.
If
gold
k k <
* *
time
t
0
c
i
y
slide 44
CHAPTER 7 Economic Growth I
Population growth
Assume that the population (and labor force)
grow at rate n. (n is exogenous.)

EX: Suppose L = 1,000 in year 1 and the
population is growing at 2% per year (n = 0.02).
Then AL = n L = 0.02 1,000 = 20,
so L = 1,020 in year 2.
A
=
L
n
L
slide 45
CHAPTER 7 Economic Growth I
Break-even investment
(o + n)k = break-even investment,
the amount of investment necessary
to keep k constant.
Break-even investment includes:
o k to replace capital as it wears out
n k to equip new workers with capital
(Otherwise, k would fall as the existing capital stock
would be spread more thinly over a larger
population of workers.)
slide 46
CHAPTER 7 Economic Growth I
The equation of motion for k
With population growth,
the equation of motion for k is
break-even
investment
actual
investment
Ak = s f(k) (o + n) k
slide 47
CHAPTER 7 Economic Growth I
The Solow model diagram
Investment,
break-even
investment
Capital per
worker, k
sf(k)
(o + n ) k
k
*

Ak = s f(k) (o +n)k
slide 48
CHAPTER 7 Economic Growth I
The impact of population growth
Investment,
break-even
investment
Capital per
worker, k
sf(k)
(o +n
1
) k
k
1
*

(o +n
2
) k
k
2
*

An increase in n
causes an
increase in break-
even investment,
leading to a lower
steady-state level
of k.
slide 49
CHAPTER 7 Economic Growth I
Prediction:
Higher n lower k*.
And since y = f(k) ,
lower k* lower y*.
Thus, the Solow model predicts that countries
with higher population growth rates will have
lower levels of capital and income per worker in
the long run.
slide 50
CHAPTER 7 Economic Growth I
International evidence on population
growth and income per person
100
1,000
10,000
100,000
0 1 2 3 4 5
Population Growth
(percent per year; average 1960-2000)
Income
per Person
in 2000
(log scale)
slide 51
CHAPTER 7 Economic Growth I
The Golden Rule with population
growth
To find the Golden Rule capital stock,
express c
*
in terms of k
*
:
c
*
= y
*
i
*

= f (k
*
) (o + n) k
*

c
*
is maximized when
MPK = o + n
or equivalently,
MPK o = n
In the Golden
Rule steady state,
the marginal product
of capital net of
depreciation equals
the population
growth rate.
slide 52
CHAPTER 7 Economic Growth I
Alternative perspectives on
population growth
The Malthusian Model (1798)
Predicts population growth will outstrip the Earths
ability to produce food, leading to the
impoverishment of humanity.
Since Malthus, world population has increased
sixfold, yet living standards are higher than ever.
Malthus omitted the effects of technological
progress.
slide 53
CHAPTER 7 Economic Growth I
Alternative perspectives on
population growth
The Kremerian Model (1993)
Posits that population growth contributes to
economic growth.
More people = more geniuses, scientists &
engineers, so faster technological progress.
Evidence, from very long historical periods:
As world pop. growth rate increased, so did rate
of growth in living standards
Historically, regions with larger populations have
enjoyed faster growth.
Chapter Summary
1. The Solow growth model shows that, in the long
run, a countrys standard of living depends
positively on its saving rate
negatively on its population growth rate
2. An increase in the saving rate leads to
higher output in the long run
faster growth temporarily
but not faster steady state growth.
CHAPTER 7 Economic Growth I
slide 54
Chapter Summary
3. If the economy has more capital than the
Golden Rule level, then reducing saving will
increase consumption at all points in time,
making all generations better off.
If the economy has less capital than the Golden
Rule level, then increasing saving will increase
consumption for future generations, but reduce
consumption for the present generation.
CHAPTER 7 Economic Growth I
slide 55