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Macroeconomics 2. The Long-run Development of Economies

Explore the Solow-Swan model and sustainable steady state doctrines in the long-run development of economies. Learn about structural changes and growth theories. Literature review references included.

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Macroeconomics 2. The Long-run Development of Economies

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  1. Macroeconomics2. The Long-run Development of Economies Prof. Dr. Rainer Maurer

  2. Macroeconomics 2. The Long-run Development of Economies 2.1. The Solow-Swan Model of a Closed Economy 2.2. Several Doctrines for a Sustainable Steady State 2.2.1. Steady States and Exhaustible Resources 2.2.2. Solow's Substitution Optimism 2.2.3. Alternative Doctrines 2.3. Understanding Structural Change 2.4. Questions for Review Literature: ◆ Chapter 24, Mankiw, N.G.: Principles of Economics, Harcourt College Publisher ◆ Kapitel 15, Siebert, Horst; Einführung in die Volkswirtschaftslehre; Kohlhammer. ◆ Kapitel 27, Abschnitt 9, Baßler, Ulrich, et al.; Grundlagen und ProblemederVolkswirtschaft, Schäfer-Pöschel. Prof. Dr. Rainer Maurer

  3. 2. The Long-run Development of Economies 2. The Long-run Development of Economies 2.1. The Solow-Swan Model of a Closed Economy Prof. Dr. Rainer Maurer

  4. 1,1% p.a. 2,6% p.a. Prof. Dr. Rainer Maurer Source: SVG, Jg. 2004/5

  5. Prof. Dr. Rainer Maurer Source: Penn World Tables, NBER

  6. 2.1. The Solow-Swan Model of a Closed Economy • Basic idea of the Solow-Swan model (1): • GDP will grow, if a country is able to accumulate production factors from one year to the other: • Accumulating production factors are not completely worn out in the production of one period, e.g.: • Capital Equipment (Machines, Production Facilities) • Human Capital (Knowledge and Abilities of Humans) • Technical Knowledge (Blueprints, Incorporated Knowledge) • To simplify the analysis, we start with keeping all production factors but capital equipment constant. • Later on, we will analyze, what happens, if one of the other production factors changes. Prof. Dr. Rainer Maurer

  7. Payment for Consumption of Households Payment for Prod. Factors Investment > Depreciation Savings = Investment The Basic Idea of the Solow-Swan Model. 1st Period + Growth of Capital Stock Prof. Dr. Rainer Maurer

  8. + + Consumption of Households Payment for Prod. Factors Investment > Depreciation Savings = Investment The Basic Idea of the Solow-Swan Model . 2nd Period Growth of Capital Stock Prof. Dr. Rainer Maurer

  9. + + + Consumption of Households Payment for Prod. Factors Investment > Depreciation Savings = Investment The Basic Idea of the Solow-Swan Model . 3rd Period Growth of Capital Stock Prof. Dr. Rainer Maurer

  10. The Basic Idea of the Solow-Swan Model . • Growth Performance after Three Periods: =Growth Prof. Dr. Rainer Maurer

  11. 2.1. The Solow-Swan Model of a Closed Economy • How long does GDP growth go on ? = How long does the capital stock grow ? • As long as gross investment (It)is larger than capital depreciation(λ*Kt) (= yearly wearout of capital equipment): Kt+1 = Kt + It – λ * Kt • Since the capital market interest rate ensures the equivalence of investment and savings, this means that a closed economy grows as long as savings are larger than capital depreciation. > => Kt+1 > Kt Prof. Dr. Rainer Maurer

  12. + + + Consumption of Households Payment for Prod. Factors Investment = Depreciation Savings = Investment The Basic Idea of theSolow-Swan Model . Steady State! No additional dredge! = No further Growth of the Capital Stock Prof. Dr. Rainer Maurer

  13. 2.1. The Solow-Swan Model of a Closed Economy • Graphical Exposition of the Solow-Swan-Model: • To simplify the graphical exposition, we assume that savings are always a constantfraction “s” of household income: • Example: For a savings ratio of 10% (s = 0,1) and an income of 100 000 € (= Y) savings equal 10 000 € (s * Y = 0.1 * 100 000 = 10 000). • From the empirical point of view, saving ratios of most countries lie in the range of 5% - 15%. Germany has a savings ratio of roughly 11%. Prof. Dr. Rainer Maurer

  14. 2.1. The Solow-Swan Model of a Closed Economy Y Y(A,B,P,L,H,K) If this curve describes GDP dependent on the capital stock K, how will the savings curve look like? K Prof. Dr. Rainer Maurer

  15. 2.1. The Solow-Swan Model of a Closed Economy Y Y(A,B,P,L,H,K) S = s * Y(A,B,P,L,H,K) K Prof. Dr. Rainer Maurer

  16. 2.1. The Solow-Swan Model of a Closed Economy • What do households make with their savings? • They offer their savings as credits to the capital market. • Who demands household savings on the capital market? • Firms • What equilibrates household savings with firms demand for credits? • The interest rate (market mechanism) Prof. Dr. Rainer Maurer

  17. The Capital Market i S = s*Y Excess Supply => Interest decreases. i1 i* i2 I(i,K) Excess Demand => Interest increases. I, S I = S Prof. Dr. Rainer Maurer

  18. The Capital Market i S = s*Y The interest rate equilibrates savings supply of households S=s*Y with credit demand of firms I(i,K). Therefore savings equal investment: I(i,K) = S = s*Y. i1 i* i2 I(i,K) I, S I = S Prof. Dr. Rainer Maurer

  19. 2.1. The Solow-Swan Model of a Closed Economy • Consequently, the market mechanism of the capital market “takes care” for the equivalence of investment and savings. • This simplifies the following analysis, since we can equatesavings and investment. • In other words: Once we have determined savings, we have determined investment. S(Y) = I(i) Prof. Dr. Rainer Maurer

  20. 2.1. The Solow-Swan Model of a Closed Economy Y Y(A,B,P,L,H,K) K * λ S = s*Y= I K * λ = per Period Depreciation of Capital Stock 5 => λ = 5/7 = 71% = Depreciation Ratio K Prof. Dr. Rainer Maurer 7

  21. 2.1. The Solow-Swan Model of a Closed Economy Up to where will GDP grow, if the capital stock equals Kt? Y Y(A,B,P,L,H,K) K * λ S = s*Y= I K Kt Prof. Dr. Rainer Maurer

  22. 2.1. The Solow-Swan Model of a Closed Economy Y Y(A,B,P,L,H,K) K*λ Yt S = s*Y= I Ct St = It K Kt Prof. Dr. Rainer Maurer

  23. 2.1. The Solow-Swan Model of a Closed Economy Y Y(A,B,P,L,H,K) K*λ Yt S = s*Y= I Ct = ΔKt+1= Kt+1 – Kt Kt * λ K Prof. Dr. Rainer Maurer Kt

  24. 2.1. The Solow-Swan Model of a Closed Economy Y Y(A,B,P,L,H,K) K*λ Yt S = s*Y= I Ct = ΔKt+1= Kt+1 - Kt Kt * λ K Prof. Dr. Rainer Maurer Kt ΔKt+1 Kt+1

  25. 2.1. The Solow-Swan Model of a Closed Economy Y Y(A,B,P,L,H,K) K*λ Yt+1 Ct+1 Yt S = s*Y= I = ΔKt+2= Kt+2 – Kt+1 Kt+1 * λ K Prof. Dr. Rainer Maurer Kt Kt+1 Kt+2 ΔKt+2

  26. 2.1. The Solow-Swan Model of a Closed Economy Y Y(A,B,P,L,H,K) Yt+2 K*λ Yt+1 Ct+2 Yt S = s*Y= I = ΔKt+3= Kt+3 – Kt+2 Kt+2 * λ K Prof. Dr. Rainer Maurer Kt Kt+2 Kt+1 Kt+3 ΔKt+3

  27. 2.1. The Solow-Swan Model of a Closed Economy Y Y(A,B,P,L,H,K) Yt+3 Yt+2 K*λ Yt+1 Ct+3 Yt S = s*Y= I = ΔKt+4= Kt+4 – Kt+3 Kt+3 * λ K Prof. Dr. Rainer Maurer Kt Kt+2 Kt+3 Kt+1 ΔKt+4 Kt+4

  28. 2.1. The Solow-Swan Model of a Closed Economy Y Y(A,B,P,L,H,K) Y* Yt+4 Yt+3 Yt+2 K*λ Yt+1 C* Yt s*Y(A,B,P,L,H,K)= I K*+1 – K*= 0 I*t = Kt * λ Steady State! K K * Prof. Dr. Rainer Maurer Kt+2 Kt+3 Kt+4 Kt+1

  29. => 2.1. The Solow-Swan Model of a Closed Economy • What happens to the capital stock of a country, if one of the other production factors is increased (for some reason)? Prof. Dr. Rainer Maurer

  30. 2.1. The Solow-Swan Model of a Closed Economy Y(A1,B,P,L,H,K) Y K*λ Yt Primary Effect Y(A0,B,P,L,H,K) Y*t s*Y(A0,B,P,L,H,K)= I K K*t Prof. Dr. Rainer Maurer

  31. 2.1. The Solow-Swan Model of a Closed Economy Y(A1,B,P,L,H,K) Y K*λ Yt Y(A0,B,P,L,H,K) s*Y(A1,B,P,L,H,K)= I Y*t s*Y(A0,B,P,L,H,K)= I K K*t Prof. Dr. Rainer Maurer

  32. 2.1. The Solow-Swan Model of a Closed Economy Y(A1,B,P,L,H,K) Y K*λ Yt s*Y(A1,B,P,L,H,K) Y*t K K*t Prof. Dr. Rainer Maurer

  33. 2.1. The Solow-Swan Model of a Closed Economy Y(A1,B,P,L,H,K) Y K*λ Yt s*Y(A1,B,P,L,H,K) K Kt Prof. Dr. Rainer Maurer

  34. 2.1. The Solow-Swan Model of a Closed Economy Y(A1,B,P,L,H,K) Y K*λ Yt Ct s*Y(A1,B,P,L,H,K) Kt+1 - Kt Kt * λ K Kt Prof. Dr. Rainer Maurer

  35. 2.1. The Solow-Swan Model of a Closed Economy Y(A1,B,P,L,H,K) Y Y* K*λ Secondary Effect Yt Y(A1,B,P,L,H,K) Primary Effect s*Y(A1,B,P,L,H,K) Y*t K Kt K* Prof. Dr. Rainer Maurer

  36. 2.1. The Solow-Swan Model of a Closed Economy Y(A1,B,P,L,H,K) Y Y* K*λ Yt s*Y(A1,B,P,L,H,K) What factors determine the long run steady state level of GDP? K Kt K* Prof. Dr. Rainer Maurer

  37. 2.1. The Solow-Swan Model of a Closed Economy • To sum up: • The Solow-Swan model explains, what factors of production determine the level of GDP in the long run. • Basic Mechanism: Accumulation of production factors: • Physical Capital • Human Capital • Technological Knowledge • Public Goods • If the Solow-Swan model correctly describes reality, an increase in these production factors should increase GDP and vice versa. Prof. Dr. Rainer Maurer

  38. 2.1. The Solow-Swan Model of a Closed Economy • The following graphs also reveal the strong effect of the capital stock growth on GDP growth for Germany. Prof. Dr. Rainer Maurer

  39. Prof. Dr. Rainer Maurer Source: AMECO-Database EU-Commission

  40. Prof. Dr. Rainer Maurer Source: AMECO-Database EU-Commission

  41. 2. The Long-run Development of Economies 2. The Long-run Development of Economies 2.1. The Solow-Swan Model of a Closed Economy 2.2. Several Doctrines for a Sustainable Steady State 2.2.1. Steady States and Exhaustible Resources Prof. Dr. Rainer Maurer

  42. 2.2. Several Doctrines for a Sustainable Steady State2.2.1. Steady States and Exhaustible Resources • The "steady state" of an economy, as derived in the preceding section, is a situation, where GDP neither grows nor shrinks over time. • In this version of the Solow-Swan model, such a situation is possible, because the problem of exhaustible resources is neglected. • The implicit assumption was, all production factors are either • "renewable resources“ (they reproduce themselves in every period). • or they are accumulating, i.e. they are used up in every period to a certain amount ("capital depreciation"), but this amount can be replaced by investment. • This version of the Solow-Swan model takes not care of the problem of "exhaustible" resources, i.e. production factors that do not reproduce themselves and/or whose erosion cannot be replaced by investment goods. For example: fossil fuels, metals, minerals… • It is clear that in the presence of a exhaustible resources, which are necessary for GDP production, the achievement of a durablesteady state can become much more difficult. Prof. Dr. Rainer Maurer -\ Exercise 18

  43. A useful reclassification of production factors: Renewable Resources: Exhaustible Resources: Accumulating production factors, which are produced with production factors: Ideal type: Fossil Fuels, Metals, Minerals, Ideal type: Solar, Wind & Geothermal Energy K = Physical Capital A = Technological Knowledge H = Human Capital P= Public Goods Conditional: Forests, Water, Air, Uptake Capacity of Environment, Labor... (IF "OVERUSED") Conditional: Forests, Water, Air, Uptake Capacity of Environment, Labor... (IF NOT "OVERUSED") Renewable (exhaustible) if produced with renewable (exhaustible) resources. Prof. Dr. Rainer Maurer

  44. A useful reclassification of production factors: Renewable Resources: Exhaustible Resources: Accumulating production factors, which are produced with production factors: Consumption of Households Payment for Prod. Factors Steady State Investment = Depreciation Steady state possible, if produced with renewable or substitutable resources. Steady state possible, if not "overused" Steady state possible if substitutable… Prof. Dr. Rainer Maurer

  45. 2.2. Several Doctrines for a Sustainable Steady State2.2.2. Alternative Doctrines IPCC-Forecast for the year 2100: 750 – 900 EJ Solar Energy per Year= 3,85 Millionen Exajoules Human Energy Consumption per Year = 497 EJ Solar energy that arrives at the earth in 1 hour and 8 minutes equals 100% of yearly human energy consumption. => Prof. Dr. Rainer Maurer

  46. 2. The Long-run Development of Economies 2. The Long-run Development of Economies 2.1. The Solow-Swan Model of a Closed Economy 2.2. Several Doctrines for a Sustainable Steady State 2.2.1. Steady States and Exhaustible Resources 2.2.3. Solow's Constant Capital Rule DON'T PANIC — Hans Rosling showing the facts about population: https://www.youtube.com/watch?v=FACK2knC08E Prof. Dr. Rainer Maurer

  47. 2.2. Several Doctrines for a Sustainable Steady State4.2.2. Solow's Constant Capital Rule • Solow's "elasticity of substitution optimism": „The world can, in effect, get along without natural resources, so exhaustion is just an event, not a catastrophe.“ Solow, R. (1974): The Economics of Resources or the Resources of Economics, American Economic Review • Solow shows that, if there is "enough substitutability" between exhaustible resources and accumulating production factors, it will always be possible to meet the following maximin-welfare criterion: "…the current generation is always entitled to take as much out of the common intertemporal pool as it can, provided only that it leaves behind the possibility that eachsucceeding generation can be as well off as this one.“ Solow, R. (1986): On the Intergenerational Allocation of Natural Resources, in: Scandinavian Journal of Economics • In other words, this criterion is fulfilled, if the current generation leaves enough production factors to all future generations, that these generations can realize per-capita consumption levels at least as high as the current generation (maximin-criterion). Prof. Dr. Rainer Maurer

  48. 2.2. Several Doctrines for a Sustainable Steady State4.2.2. Solow's Constant Capital Rule • Solow's constant capital rule, sometime also called "neoclassical sustainability" or "very weak sustainability" (VWS) is based on two kind of value judgments: • A normative value judgment (or "ethical rule"), according to which " the current generation shall leave enough production factors to all future generations, such that these generations can realize at least as high per-capita consumption levels as the current generation (maximin-criterion)." • An empirical value judgment (or "technical presumption"), according to which one of the above three sets for "enough substitutability" (sl. 68) between accumulating and exhaustible production factors is always fulfilled. • As always such value judgments are debatable, i.e. there is no logical necessity to accept them. • In the following a couple of well-known alternative point of views are surveyed: Prof. Dr. Rainer Maurer

  49. 2. The Long-run Development of Economies 2. The Long-run Development of Economies 2.1. The Solow-Swan Model of a Closed Economy 2.2. Several Doctrines for a Sustainable Steady State 2.2.1. Steady States and Exhaustible Resources 2.2.3. Solow's Constant Capital Rule 2.2.3. Alternative Sustainablity Doctrines Prof. Dr. Rainer Maurer

  50. 2.2. Several Doctrines for a Sustainable Steady State2.2.2. Alternative Doctrines Prof. Dr. Rainer Maurer

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