CHAP07

N.
Gregory Mankiw
PowerPoint Slides by Ron Cronovich
CHAPTE
R
Economic Growth I:
Capital Accumulation and
http://downloadslide.blogspot.com
Population Growth
2010 Worth Publishers, all rights reserved
SEVENTH EDITIO
MACROECONOMICS
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
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.
CHAPTER 7
Economic Growth I
Income and poverty in the world

selected countries, 2000
Madagascar
India
Nepal
Bangladesh
Botswana
Kenya
China
Peru
Mexico
Thailand
Brazil
Russian
Federation
Chile
S. Korea
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.
percentage increase in
standard of living after
annual growth
rate of income
per capita
25 years
50 years
100 years
2.0%
64.0%
169.2%
624.5%
2.5%
85.4%
243.7%
1,081.4%
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.
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
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
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
CHAPTER 7
Economic Growth I
10
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
CHAPTER 7
Economic Growth I
11
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)
CHAPTER 7
Economic Growth I
where f(k) = F(k, 1)

12
The production function

Output per
worker, y
f(k)
MPK = f(k +1) f(k)
1
Note:
Note: this
this production
production function
function
exhibits
exhibits diminishing
diminishing MPK.
MPK.
Capital per
worker, k
CHAPTER 7
Economic Growth I
13
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
CHAPTER 7
Economic Growth I
14
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)
CHAPTER 7
Economic Growth I
15
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)
CHAPTER 7
Economic Growth I
16
Output, consumption, and

investment
Output per
worker, y
f(k)
c1
sf(k)
y1
i1
k1
CHAPTER 7
Economic Growth I
Capital per
worker, k
17
Depreciation
Depreciation
per worker, k
= the rate of depreciation

= the fraction of the capital stock
that wears out each period
k
CHAPTER 7
Economic Growth I
Capital per
worker, k
18
Capital accumulation
The basic idea: Investment increases the capital
stock, depreciation reduces it.
Change in capital stock
k
= investment depreciation
=
i
Since i = sf(k) , this becomes:
k = s f(k) k
CHAPTER 7
Economic Growth I
19
The equation of motion for k
k = s f(k) 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)

CHAPTER 7
Economic Growth I
20
The steady state
k = s f(k) k
If investment is just enough to cover depreciation
[sf(k) = k ],
then capital per worker will remain constant:
k = 0.
This occurs at one value of k, denoted k*,
called the steady state capital stock.
CHAPTER 7
Economic Growth I
21
The steady state

Investment
and
depreciation
k
sf(k)
k*
CHAPTER 7
Economic Growth I
Capital per
worker, k
22
Moving toward the steady

state
Investment
and
depreciation
k = sf(k)
k
k
sf(k)
investment
depreciation
k1
CHAPTER 7
Economic Growth I
k*
Capital per
worker, k
23
Moving toward the steady state

Investment
and
depreciation
k = sf(k)
k
k
sf(k)
k
k1 k2
CHAPTER 7
Economic Growth I
k*
Capital per
worker, k
24

Investment
and
depreciation
k = sf(k)
k
k
sf(k)
investment
depreciation
k2
CHAPTER 7
Economic Growth I
k*
Capital per
worker, k
25

Investment
and
depreciation
k = sf(k)
k
k
sf(k)
k
k2 k3 k*
CHAPTER 7
Economic Growth I
Capital per
worker, k
27

Investment
and
depreciation
k = sf(k)
k
sf(k)
Summary:
Summary:
As
As long
long as
as kk << kk**,,
investment
investment will
will exceed
exceed
depreciation,
depreciation,
and
and kk will
will continue
continue to
to
grow
grow toward
toward kk**..
k3 k*
CHAPTER 7
Economic Growth I
Capital per
worker, k
28
An increase in the saving rate

An increase in the saving rate raises investment
causing k to grow toward a new steady state:
Investment
and
depreciation
k
s2 f(k)
s1 f(k)
k
CHAPTER 7
Economic Growth I
35
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.
CHAPTER 7
Economic Growth I
36
International evidence on investment

rates and income per person
Income per
person in
2003
(log scale)
Investment as percentage of output

(average 1960-2003)
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*?

CHAPTER 7
Economic Growth I
38
The Golden Rule capital stock

the Golden Rule level of capital,
the steady state value of k
that maximizes consumption.
To find it, first express c* in terms of k*:
c*
CHAPTER 7
y*
i*
= f (k*)
i*
= f (k*)
k*
Economic Growth I
In the steady state:

i* = k* because
k = 0.
39

steady state
output and
depreciation
Then, graph
f(k*) and k*,
look for the
point where
the gap between
them is biggest.
CHAPTER 7
Economic Growth I
k*
f(k*)
steady-state
capital per
worker, k*
40

cc** == f(k
f(k**))
k
k**
is
is biggest
biggest where
where
the
the slope
slope of
of the
the
production
production function
function
equals
equals
the
the slope
slope of
of the
the
depreciation
depreciation line:
line:
k*
f(k*)
MPK =
CHAPTER 7
Economic Growth I
steady-state
capital per
worker, k*
41
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?
CHAPTER 7
Economic Growth I
42
Starting with too much capital
then
then increasing
increasing cc
requires
requires aa fall
fall in
in s.
s.
**
c
In
In the
the transition
transition to
to
the
the Golden
Golden Rule,
Rule,
consumption
consumption is
is
higher
higher at
at all
all points
points
in
in time.
time.
CHAPTER 7
Economic Growth I
t0
time
43
Starting with too little capital

then
then increasing
increasing cc**
requires
requires an
an
increase
increase in
in s.
s.
Future
Future generations
generations
enjoy
enjoy higher
higher
consumption,
consumption,
but
but the
the current
current
one
one experiences
experiences
an
an initial
initial drop
drop
in
in consumption.
consumption.
CHAPTER 7
y
c
Economic Growth I
t0
time
44
Population growth
Assume the population and labor force grow
at rate n (exogenous):
EX: Suppose L = 1,000 in year 1 and the

population is growing at 2% per year (n = 0.02).
Then L = n L = 0.02 1,000 = 20,

so L = 1,020 in year 2.
CHAPTER 7
Economic Growth I
45
Break-even investment
( + n)k = break-even investment,

the amount of investment necessary
to keep k constant.
Break-even investment includes:

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
is spread more thinly over a larger population of
workers.)
CHAPTER 7
Economic Growth I
46
The equation of motion for k

With population growth,
the equation of motion for k is:
k = s f(k) ( + n) k
actual
investment
CHAPTER 7
Economic Growth I
break-even
investment
47
The Solow model diagram

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

growth
Investment,
break-even
investment
( +n2) k
( +n1) k
An increase in n
causes an increase
in break-even
investment,
leading to a lower
steady-state level
of k.
sf(k)
k2*
CHAPTER 7
Economic Growth I
k1* Capital per

worker, k
49
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.
CHAPTER 7
Economic Growth I
50
International evidence on population

growth and income per person
Income per
person in
2003
(log scale)
Population growth
(percent per year, average 1960-2003)
The Golden Rule with population

growth
To find the Golden Rule capital stock,
express c* in terms of k*:
c* =
y*
= f (k* )
i*
( + n) k*
c* is maximized when
MPK = + n
or equivalently,
MPK = n
CHAPTER 7
Economic Growth I
In the Golden
Rule steady state,
the marginal product
of capital net of
depreciation equals
the population
growth rate.
52
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 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.

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N.

In this chapter, you will learn:

how to use the Golden Rule to find the

Why growth matters

Poverty is associated with oppression of women

Income and poverty in the world

Why growth matters

Why growth matters

The lessons of growth theory

The Solow model

looks at the determinants of economic growth

How Solow model is different

investment causes it to grow,

population growth causes it to grow

How Solow model is different

(only to simplify presentation;

The production function

Assume constant returns to scale:

Pick z = 1/L. Then

where f(k) = F(k, 1)

The production function

The national income identity

The consumption function

Consumption function: c = (1s)y

Saving and investment

National income identity is y = c + i

Using the results above,

Output, consumption, and

= the rate of depreciation

Since i = sf(k) , this becomes:

The equation of motion for k

income per person:

consumption per person: c = (1s) f(k)

The steady state

The steady state

Moving toward the steady

Moving toward the steady state

Moving toward the steady state

Moving toward the steady state

Moving toward the steady state

An increase in the saving rate

Higher s higher k*.

Thus, the Solow model predicts that countries

International evidence on investment

Investment as percentage of output

The Golden Rule: Introduction

The best steady state has the highest possible

So, how do we find the s and k* that maximize c*?

The Golden Rule capital stock

In the steady state:

The Golden Rule capital stock

The Golden Rule capital stock

The transition to the

Achieving the Golden Rule requires that

This adjustment leads to a new steady state

But what happens to consumption

Starting with too much capital

Starting with too little capital

EX: Suppose L = 1,000 in year 1 and the

Then L = n L = 0.02 1,000 = 20,