macroeconomics & the global economy ace institute of management chapter 7 and 8: economic growth...

Macroeconomics & The Macroeconomics & The Global EconomyGlobal Economy

Ace Institute of ManagementAce Institute of Management

Chapter 7 and 8: Economic Growth IChapter 7 and 8: Economic Growth I

Instructor

Sandeep Basnyat

[email protected]

9841 892281

CHAPTER 7CHAPTER 7 Economic Growth I Economic Growth I slide 2

The Solow or Neo Classical ModelThe 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– Labour Force– Technological Progress

Factors of Production

- Production Function


The Solow Model- Accumulation of The Solow Model- Accumulation of

Capital Stock in an EconomyCapital Stock in an Economy How much capital an economy can

accumulate depends on:

– supply of goods (Output) : depends on Production function

– demand of goods (Input): depends on Consumption function


The production functionThe production function

In aggregate terms: Y = F (K, L )

Define: 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)Amount of Output per worker (Y/L) is the

function of amount of capital per worker (K/L) .


The production functionThe production function

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).


The production functionThe production functionOutput per worker, y

Capital per worker, k

f(k)

Note: this production function exhibits diminishing MPK.

Note: this production function exhibits diminishing MPK.

1MPK

Note:When capital per worker is high, extra unit of capital produces lower output

Vice Versa.


The Demand for Goods and ServicesThe 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.


The Demand for Goods and ServicesThe Demand for Goods and Services

Substituting the value of ‘c’ in y;

y = (1-s)y + i or

i = sy

Shows that investment equals saving

where ‘s’ is the fraction of the output/

income devoted to investment.


Basis of Neo-Classical Growth ModelBasis 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?


Basis of Neo-Classical Growth ModelBasis 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 to total income. Therefore, savings and/or investment at different capital stocks can be presented as a part of the total output (Income).


Graphical representation without TechnologyGraphical representation without Technology

Capital Per Worker

Ou

tpu

t P

er W

ork

er

Steady State


The model and increase in the saving rateThe model and increase in the saving rate

Capital Per Worker

Out

put P

er W

orke

r


The model and increase in populationThe model and increase in population


Effect of Technological AdvancementEffect of Technological Advancement

y’ = f(k)

ir = dk

i = s f(k)

k

y

k*

y*i = s' f(k)

k1*

y*’ y = f(k)

•Productivity per worker increases

•Shifts the Production 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”


Golden Rule Level of CapitalGolden Rule Level of Capital

•Bench mark for highest level of movement of steady state

•The Golden Rule level of capital accumulation is the steady state with the highest level of consumption.

y = f(k)

ir = dk

i = s f(k)

k

y

C*gold

I*gold

k*gold


Policy issues: Policy issues: How to increase the saving rate?How to increase the saving rate?

Reduce the government budget deficit(or increase the budget surplus).

Increase incentives for private saving. Example: Reduce tax


Policy issues: Policy issues: Allocating the economy’s investmentAllocating the economy’s investment

In the Solow model, there’s 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?


Policy issues: Policy issues: Allocating the economy’s investmentAllocating the economy’s 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 don’t consider.


Policy issues: Policy issues: Establishing the right institutionsEstablishing 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.


Policy issues: Policy issues: Encouraging tech. progressEncouraging 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


Thank YouThank You

macroeconomics & the global economy ace institute of management chapter 7 and 8: economic growth...

Documents

production function

economic growth

worker output

consumption function

production function

production function

worker terms

extra output