Performance of World Economies

1. Performance of World Economies Gavin Cameron University of Oxford OUBEP 2006

2. “Is there some action a government of India could take that would lead the Indian economy to grow like Indonesia’s or Egypt’s? If so, what, exactly? If not, what is it about the “nature of India” that makes it so? The consequences for human welfare involved in questions like these are simply staggering: Once one starts to think about them, it is hard to think about anything else”, Robert Lucas, 1988. introduction OXFORD UNIVERSITY BUSINESS ECONOMICS PROGRAMME

3. important elements of long-run growth • Technical Change (q.v. Smith’s pin factory) • Over time, technology becomes more advanced, and hence output per worker rises; • Factor Accumulation (q.v. Ramsey on saving) • Over time, with sensible property rights, people accumulate capital assets (physical, human and environmental), even though factors are typically subject to diminishing returns; • Factor Substitution (cf. Ricardo on land) • Over time, factors cannot earn economic rents unless their supply is restricted, even then, other factors can be used as substitutes; • Product Substitution (q.v. Schumpeter on creative destruction) • Over time, new varieties and qualities of products are developed, which replace previous types. OXFORD UNIVERSITY BUSINESS ECONOMICS PROGRAMME

4. Per capita output grows over time and its growth rate does not tend to diminish; the same is true of real wages; Physical capital per worker grows over time; The rate of return to capital is nearly constant; The ratio of physical capital to output is nearly constant; The shares of labour and physical capital in national income are nearly constant; The growth rate of output per worker differs substantially across countries. Kaldor’s stylised facts OXFORD UNIVERSITY BUSINESS ECONOMICS PROGRAMME

5. Source: Robert J Gordon (2005)

6. diminishing returns Output per worker (K/L) Output per worker, Y/L Output is produced using a diminishing returns production technology. As more capital is added, the additional increment to output gets smaller. The shape of the curve reflects the production technology – it gets flatter as the output elasticity of capital falls, and steeper as it rises. Capital per worker (K/L) OXFORD UNIVERSITY BUSINESS ECONOMICS PROGRAMME

7. ... a constant saving rate… Output per worker (K/L) Some constant fraction, s, of output is saved. This saving takes the form of new capital goods. Saving per worker, sY/L Capital per worker (K/L) OXFORD UNIVERSITY BUSINESS ECONOMICS PROGRAMME

8. …and a constant depreciation rate Output per worker (K/L) Required Investment per worker, (n+d)K/L Gross investment is required each year, since the stock of capital per worker falls because of physical depreciation and because of labour force growth. Capital per worker (K/L) OXFORD UNIVERSITY BUSINESS ECONOMICS PROGRAMME

9. …the Solow model Output per worker (K/L) Output per worker, Y/L The economy is in equilibrium when net investment is zero. Required Investment per worker, (n+d)K/L Saving per worker, sY/L Rate of convergence is an increasing function of s, and a decreasing function of n+d and the output elasticity of capital Capital per worker (K/L) K*/L OXFORD UNIVERSITY BUSINESS ECONOMICS PROGRAMME

10. a rise in the saving rate Output per worker (K/L) Output per worker, Y/L Required Investment per worker, (n+d)K/L s’Y/L sY/L The increase in investment raises the growth rate temporarily as the economy moves to a new steady-state. But once the new higher steady-state level of income is reached, the growth rate returns to its previous level. Capital per worker (K/L) OXFORD UNIVERSITY BUSINESS ECONOMICS PROGRAMME

11. faster population growth Output per worker (K/L) Output per worker, Y/L Required Investment per worker (n’+d)K/L (n+d)K/L The rise in population growth means that more workers need to be equipped with capital each time period, which means that less is available for replacing depreciated equipment. This leads to a fall in the steady-state level of capital. Capital per worker (K/L) OXFORD UNIVERSITY BUSINESS ECONOMICS PROGRAMME

12. the golden rule Output per worker (K/L) Output per worker, Y/L Required Investment per worker, (n+d)K/L C/L The goal of a social planner might be to maximise consumption per capita (where consumption is largest relative to investment per worker). This occurs where the slope of the output per worker curve is the same as the slope of the depreciation per worker curve. The implied saving rate is likely to be different from the market outcome. I/L Capital per worker (K/L) OXFORD UNIVERSITY BUSINESS ECONOMICS PROGRAMME

13. the poverty trap - industrialisation Output per worker (K/L) Required Investment per worker, (n+d)K/L high income: industrial Saving per worker medium income: mixed low income: agricultural Capital per worker (K/L) OXFORD UNIVERSITY BUSINESS ECONOMICS PROGRAMME

14. the poverty trap – endogenous fertility Output per worker (K/L) Required Investment per worker, (n’+d)K/L Saving per worker high income: low fertility, low mortality medium income: low fertility, high mortality low income: high fertility, high mortality Capital per worker (K/L) OXFORD UNIVERSITY BUSINESS ECONOMICS PROGRAMME

15. the AK model Output per worker, Y/L Output per worker (K/L) If there are constant returns to broad capital, net investment might always be positive, so there is no equilibrium level of output per worker. Saving per worker, sY/L Required investment per worker, (n+d)K/L Capital per worker (K/L) OXFORD UNIVERSITY BUSINESS ECONOMICS PROGRAMME

16. The Solow model model has two main predictions: For countries with the same steady-state, poor countries should grow faster than rich ones. An increase in investment raises the growth rate temporarily as the economy moves to a new steady-state. But once the new higher steady-state level of income is reached, the growth rate returns to its previous level – there is a levels effect but not a growth effect. However, the AK model yields the opposite predictions – there is no convergence, and policy changes can have permanent effects. Solow vs AK K/L Solow world ‘levels effect’ K*/L ‘catch-up’ t K/L AK world ‘growth effect’ no ‘catch-up’ t OXFORD UNIVERSITY BUSINESS ECONOMICS PROGRAMME

17. Source: O’Mahony and Van Ark (2003) OXFORD UNIVERSITY BUSINESS ECONOMICS PROGRAMME

18. twin peaks number of countries Since the 1960s, the distribution of world log income has tended to become more twin-peaked than before. Danny Quah argues that open economies tend to be in the higher peak. 1960 1990 income OXFORD UNIVERSITY BUSINESS ECONOMICS PROGRAMME

19. the sources of economic growth • Growth of output = weighted growth of inputs + growth of total factor productivity • Growth of labour productivity = weighted growth of capital per worker + growth of total factor productivity • Growth of inputs • Capital and labour • Materials and energy • Growth of total factor productivity • Higher quality products • New varieties of products • Better ways to use existing inputs OXFORD UNIVERSITY BUSINESS ECONOMICS PROGRAMME

20. growth accounting Output per worker (K/L) Output per worker, Y’/L C B Output per worker, Y/L A A rise in technology raises the steady-state level of output per capita. Part of this rise (AB) is the pure effect of technical change (TFP), the other part (BC) is due to ensuing capital accumulation. Capital per worker (K/L) OXFORD UNIVERSITY BUSINESS ECONOMICS PROGRAMME

21. Source: O’Mahony and Van Ark (2003), table 1.4b. OXFORD UNIVERSITY BUSINESS ECONOMICS PROGRAMME

22. Source: O’Mahony and Van Ark (2003), table III.14. OXFORD UNIVERSITY BUSINESS ECONOMICS PROGRAMME

23. Source: O’Mahony and Van Ark (2003), table III.5. OXFORD UNIVERSITY BUSINESS ECONOMICS PROGRAMME

24. high productivity countries • Institutions that favour production over diversion: low corruption, private property, good institutions; • Low rate of government consumption (i.e. spending excluding investment & transfers); • Open to international trade; • Well-educated workforce; • International language; • Temperate latitude away from the equator; • Easy access to coast and ports. OXFORD UNIVERSITY BUSINESS ECONOMICS PROGRAMME

25. long-run growth • Unemployment and business cycles are important in explaining short and medium run growth, but play almost no rôle in the long-run: in the long-run, national output is determined by supply. • In the long-run, the main source of rising living standards is rising output per worker. • Rising output per worker is due to the steady accumulation of capital (human, physical, social, environmental) and technological progress, promoted by a supportive economic environment. • The simple Solow model shows that there is an equilibrium level of capital per worker in the absence of technological progress. Recent ‘post-neoclassical endogenous growth models’ attempt to explain technological progress. OXFORD UNIVERSITY BUSINESS ECONOMICS PROGRAMME

26. “Productivity Growth isn’t everything, but in the long-run, it is almost everything”, Paul Krugman, 1990. summary OXFORD UNIVERSITY BUSINESS ECONOMICS PROGRAMME

27. syndicate topics • How do an increased saving rate or an increased population growth rate affect the Solow model? • Should we expect poor or large countries to grow faster than rich or small ones? • Assess the relative importance of investment, competition, enterprise, innovation, and skills on productivity growth. • What factors do you think explain the above five drivers? • Why are some countries rich and others poor? • Does faster growth mean higher unemployment? OXFORD UNIVERSITY BUSINESS ECONOMICS PROGRAMME

28. optional spreadsheet task • The country of Davymania starts with 100 units of capital and 30 workers. The working population grows at 2% per annum and capital depreciates at 8% per annum. Output is produced according to the production function Y=√K.√L and the saving rate is 20%. • Use a spreadsheet to show how capital, labour, and output grow over time. • What are the equilibrium ratios of capital per worker, and output per worker in this economy? • Plot the response of capital per worker over time to (a) a change in the saving rate, (b) a change in the population growth rate, (c) a rise in efficiency that allows output to be 10% higher for any given level of capital and labour, (d) a production function of Y=K¼.L¾. • [Hard] What is the half-life of the gap between any given level of capital per worker and the equilibrium? What saving rate would maximise consumption per worker in equilibrium? OXFORD UNIVERSITY BUSINESS ECONOMICS PROGRAMME