Topic 1: Ireland’s long-run economic performance

Topic 1: Ireland’s long-run economic performance • Readings • Abel & Bernanke or other macro textbook • Chapter on long-run economic growth • Solow model and convergence • Honohan and Walsh (2002) • Blanchard (2002)

The Solow Growth Model Also known as the “neoclassical” growth model Interactive experiments available at: http://www.fgn.unisg.ch/eurmacro/tutor/solow_index.html

Cobb-Douglas production function Y = A F(K, L) = A Ka L(1-a) Y = Output A = Total Factor Productivity (TFP) K = Capital input L = Labour input

TFP (A) • A: Also called the “Solow residual” • Captures wide range of factors: • State of technology • Strength of economic and political institutions • Input utilization • Sectoral composition of output • Other stuff

Sectoral composition of output • A = economy-wide level of productivity • Consider an economy with two sectors: • 1. Agriculture = low productivity • 2. Manufacturing = high productivity • If Agriculture shrinks and Manufacturing grows, then A increases

a = elasticity of Y w.r.t. K • Exercise 1: Prove it! Also: a = capital’s share of output (1<a<0) • Exercise 2: Prove it!

Per worker version divide by L y = Af(k) = A ka where y = Y/L k = K/L Exercise 3: Prove it!

Law of motion for the capital stock: kt+1 = (1-d) kt + it Where: i = investment d = rate of depreciation

What happens to the capital stock if it = dkt kt+1 = (1-d) kt + it kt+1 = kt - dkt + it kt+1 = kt Let k* = steady-state capital stock y* = Af(k*) = steady-state output

If it > dkt then capital stock is growing If it < dkt then capital stock is shrinking

In a closed economy: Investment = Savings i = sy i = sAf(k) where s = savings rate

Convergence • Conditional convergence • If two countries have the similar A and s, but different initial k, then they will converge • If a SOE, then s not important • Absent obstacles, A’s shouldn’t be very different across advanced economies • Evidence of conditional convergence among advanced economies

Honohan and Walsh (2002) • 1990s boom was a convergence story • Convergence telescoped into one decade • No single factor accounts for 1990s boom • Why didn’t Ireland converge sooner? • Institutional preconditions for such convergence already present in 1973, but fiscal policy errors in the 1970s derailed convergence

Honohan and Walsh (2002) • Why was convergence in the 1990s so rapid? • How do we explain the employment boom?

Source: Honohan and Walsh (2002)

Fiscal Errors • See Figure 3: Budgetary Aggregates • See Figure 4: Marginal and Average Income Tax Rates, 1979-2002

Unfavorable external conditions Table 2: External conditions in the 1980s Source: Honohan and Walsh (2002)

Blanchard (2002) • Key factor behind boom: Wage moderation • Wage moderation = “wage growth below the rate consistent with technological progress.” • Low wage growth  lower costs  higher profits  higher K and L

Blanchard (2002) Recall: Y = A F(K, L) = A Ka L(1-a) • Marginal product of labour (MPL) MPL = DY/DL = (1-a)A F(K, L)/L • From micro, we know that firms choose L to equate the MPL to the market wage rate

So, for the whole economy: w = (1-a)A F(K, L)/L w/A = (1-a) F(K, L)/L w/A = (1-a) (K/L)a • Exercise 4: Prove it! • If w/A falls, then • K/L must fall • But K rises due to higher profits • So L must boom!

So wage restraint boosts investment and especially employment • Sources of wage restraint • Social partnership agreements • High unemployment • Natural demographics • Immigration • Income tax cuts

Why did wage moderation have such a large effect in Ireland? • Openness of economy • Notable amount of  K took the form of Foreign Direct Investment (FDI) • Migration flows • Available export markets • No “crowding out”

Reading for next lecture • Ahearne, Kydland, and Wynne (2005) • Barry (2002) • Fitz Gerald (2004)

Topic 1: Ireland’s long-run economic performance