L14 - Long-Run Growth III

Question 1

How does the Solow Model exhibit balanced growth?

Answer 1

•Solow model’s steady-state exhibits balanced growth—many variables grow
at the same rate.

–Solow model predicts Y/L and K/L grow at the same rate (g), so K/Y should be constant. - This is true in the real world.

–Solow model predicts real wage grows at same rate as Y/L, while real rental price is constant. - Also true in the real world.

Question 2

What does the Solow model believe will converge?

Answer 2

• Solow model predicts that, other things equal, poor countries (with lower Y/L and K/L) should grow faster than rich ones.
• If true, then the income gap between rich & poor countries would shrink over time, causing living standards to converge.
• In real world, many poor countries do NOT grow faster than rich ones. Does this mean the Solow model fails?

Question 3

Why does the Solow model fail when it predicted convergence?

Answer 3

• Solow model predicts that, ceteris paribus, poor countries (with lower Y/L and K/L) should grow faster than rich ones.
• No, because “other things” aren’t equal:

–In samples of countries with similar savings & pop. growth rates, income gaps shrink about 2% per year.

In larger samples, after controlling for differences in saving, pop. growth, and human capital, incomes converge by about 2% per year

Question 4

What does the Solow model actual predict in relation to Convergence?

Answer 4

• What the Solow model really predicts is conditional convergence—countries converge to their own steady states, which are determined by saving, population growth, and education (e.g. we have to consider human capital).
• This prediction comes true in the real world.

Question 5

What are the two reasons why income per capita are lower in some countries than others?

Answer 5

1. Differences in capital (physical or human) per worker
2. Differences in the efficiency of production (the height of the production function)

* these two reasons are implied by the Solow model

Studies:

• both factors are important
• countries with higher capital (physical or human) per worker also tend to have higher production efficiency
• Production efficiency encourages capital accumulation
• Capital accumulation has externalities that raise efficiency
• A third, unknown variable causes cap accumulation and efficiency to be higher in some countries than

Question 6

What did research by Sachs and Warner say about production efficiency?

Answer 6

•Since Adam Smith, economists have argued that free trade can increase production efficiency and living standards.

Sachs and Warner classify countries as either “open” or “closed.” Among the developed nations classified as “open,” the average annual growth rate was 2.3%. Among developed nations classified as “closed,” the growth rate was only 0.7% per year.

The average growth rate for “open” developing nations was 4.5%. The average growth rate for “closed” developing countries was only 0.7%.

Question 7

What were Frankel and Romer’s findings of production efficiency?

Answer 7

•To determine causation, Frankel and Romer exploit geographic differences among countries:

–Some nations trade less because they are farther from other nations, or landlocked.

–Such geographical differences are correlated with trade but not with other determinants of income.

–Hence, they can be used to isolate the impact of trade on income.

Findings: increasing trade/GDP by 2% causes GDP per capita to rise 1%, other things equal

Question 8

What are the policy issues that arises from the Solow model?

Answer 8

1. Are we saving enough? Or too much?
2. What policies might change the saving rate?
3. How should we allocate our investment between privately owned physical capital, public infrastructure, and “human capital”?
4. How do a country’s institutions affect production efficiency and capital accumulation?
5. What policies might encourage faster technological progress?

Question 9

How can we use the Golden rule to evaluate a countries rate of saving?

Answer 9

Question 10

What Policies can be implemented to increase the savings rate?

Answer 10

• Reduce the government budget deficit
• Increase incentives for private saving:
• reduce capital gains tax, corporate income tax, inheritance tax as they discourage saving
• replace income tax by consumption tax
• expand tax incentives for savings through retirement pension funds and other retirement savings accounts (such as ISAs)

ISAs are tax-exempt savings accounts in the U.K. Each individual is allowed to invest up to £3,000 per year in such accounts.

(or increase the budget surplus)

Question 11

What are the three types of capital in the real-world?

Answer 11

• private capital stock
• public infrastructure
• human capital: the knowledge and skills that workers acquire through education

•How should we allocate investment among these types?

1. Equalize tax treatment of all types of capital in all industries, then let the market allocate investment to the type with the highest marginal product.
2. Industrial policy: Govt should actively encourage investment in capital of certain types or in certain industries, because they may have positive externalities (by-products) that private investors don’t consider.

Question 12

What are the possible problems with industrial policy?

Answer 12

• Does the gov’t have the ability to “pick winners” (choose industries with the highest return to capital or biggest externalities)?
• Would politics (e.g. campaign contributions) rather than economics influence which industries get preferential treatment?

Question 13

What is one way we can deal with the problems that industrial policy may bring?

Answer 13

•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.

Question 14

What are different ways to encourage technological progress?

Answer 14

•Patent laws:
encourage innovation by granting temporary monopolies to inventors of new products

• Tax incentives for R&D
• Grants to fund research at universities

•Industrial policy:
encourage specific industries that are key for rapid tech. progress (subject to the preceding concerns)

Question 15

Why was their a worldwide economic slowdown from 1972-1995?

Answer 15

• •Measurement problems- Increases in productivity not fully measured
  
  • But: Why would measurement problems be worse after 1972 than before?
• Oil prices - Oil shocks occurred about when productivity slowdown began.
  
  • But: Then why didn’t productivity speed up when oil prices fell in the mid-1980s?
• Worker quality - 1970s - large influx of new entrants into labour force (baby boomers, women).
  
  • New workers are less productive than experienced workers.
• The depletion of ideas
  
  • Perhaps the slow growth of 1972-1995 is normal and the true anomaly was the rapid growth from 1948-1972

Bottom line is We don’t know which of these is the true explanation, it’s probably a combination of several of them.

Question 16

Why was their a further worldwide economic slowdown in 1995-2010?

Answer 16

The computer revolution didn’t affect aggregate productivity until the mid-1990s continuing into the mid 2000s.

Two reasons:

1. Computer industry’s share of GDP much bigger in late 1990s than earlier.
2. Takes time for firms to determine how to utilize new technology most effectively

•This period was then offset by the financial crisis and deep recession of 2008-2009

Question 17

Does capital have diminishing returns?

Answer 17

• Depends on the definition of capital.
• If capital is narrowly defined (only plant & equipment), then yes.
• Advocates of endogenous growth theory argue that knowledge is a type of capital.
• If so, then constant returns to capital is more plausible, and this model may be a good description of economic growth.

Question 18

What are three facts about R&D in the real world?

Answer 18

1. Much research is done by firms seeking profits.
2. Firms profit from research because

• •new inventions can be patented, creating a stream of monopoly profits until the patent expires
• •there is an advantage to being the first firm on the market with a new product

3. Innovation produces externalities that reduce
   the cost of subsequent innovation.

Much of the new endogenous growth theory
attempts to incorporate these facts into models to better understand tech progress.

Question 19

Is the private sector doing enough R&D?

Answer 19

• The existence of positive externalities in the creation of knowledge suggests that the private sector is not doing enough R&D.
• But, there is much duplication of R&D effort among competing firms.
• Estimates: The social return to R&D is very large (sometimes above 40% per year). Thus, many believe gov’t should encourage R&D

Question 20

Why is it argued that economic growth is ‘creative destruction’?

Answer 20

•Schumpeter (1942) coined term “creative destruction” to describe displacements resulting from technological progress:

• the introduction of a new product is good for consumers but often bad for incumbent producers, who may be forced out of the market.

Examples:

–Luddites (1811–12) destroyed machines that displaced skilled knitting workers in England.

–Walmart displaces many mom-and-pop stores.

Question 21

What is Capital Deepening and Widening?

Answer 21

• means that the capital stock will increase at the same rate as the labour force and lead to increased labour productivity (output per worker). - greater capital-labour ratio
  
  • both depreciation and the growing workforce tend to reduce the amount of capital per worker in the economy
  • the difference between s(y) and (n +d)k is the change in the amount of capital per worker
  • When this change is positive the economy is increasing its capital per worker and we say that capital deepening is occurring
• Capital widening involves greater investment to make use of existing technology and increase the amount of capital available.
  
  • When this per worker change is zero but actual capital stick K is growing (because of population growth) we say that only capital widening is occurring - constant capital to labour ratio