Lecture 6: Cross-country income differences

Question 1

what does GDP depend on?

Answer 1

• For instance, one reason why GDP is larger in some countries is that
they have a larger population
• Larger population -> more production
• Thus labor is an input in production
• We have dealt with differences in population across countries and time
by looking at GDP per capita

Question 2

Value added

Answer 2

• To produce output (value added) a firm
typically uses machines, computers and
buildings in addition to labor

• These inputs are called capital

• The efficiency at which these inputs are
transformed into value added is called
productivity

Question 3

Aggregate production function

Answer 3

This suggests that GDP per capita is a function of capital per worker and
productivity
• For simplicity, I refer to capital per worker as capital

Question 4

Returns to scale

Answer 4

• Constant returns to physical capital look as follows (straight line)
• And increasing returns as follows (parabola)

which one is more realistic?

Question 5

Productivity

Answer 5

Increase in productivity means we can produce more with the same inputs

Question 6

How does capital change over time?

Answer 6

• Investment leads to new capital
• But at the same time old capital becomes worth less. This is called depreciation. A
computer you buy now is not so useful anymore in ten years from now

Question 7

depreciation

Answer 7

computer you buy now is not so useful anymore in ten years from now

Question 8

Steady State

Answer 8

capital stock is 𝐾∗.
Capital next period is equal to capital this period.
No matter where 𝐾0 was located, this economy will always converge to this steady state.
Also when 𝐾0 is above the steady state

Question 9

Why are some countries poorer than others?

Answer 9

• Two countries that have the same production function and investment
rate will converge to the same output level
• Thus, the initial capital stock does not matter in the long-run
• And cross-country income differences and long-run growth are not
caused by differences in initial capital stocks

Question 10

What if the investment rate increases? (𝐼𝑡 =𝑠𝑌𝑡)

Answer 10

• As a larger share of output goes to investment, the capital stock is slowly
increasing to a new steady state 𝐾∗∗. At this new steady state, output is larger

Question 11

Investment rate

Answer 11

But to get sustained growth in the long run we need that the 
investment rate (or savings rate) needs to continue to grow

if so, then at one point we will spend all our income on
investment and nothing on consumption

–> not realistic

Question 12

Changes in investment rate

Answer 12

• Changes in investment rate do not explain economic growth (or cross-
country income differences)
• Let’s study change in production function
• Remember that productivity is the efficiency at which inputs are
transformed into outputs

Question 13

What if productivity increases?

Answer 13

• As productivity is increasing, output increases immediately
• Although the investment rate is constant, this means that also investment is
increasing, and capital converges to the new steady state

Question 14

What causes differences in GDP across countries

Answer 14

• Changes to productivity/technology are the driving force behind GDP
growth and differences in GDP across countries

• That the capital stock increases over time is a by-product of economic
growth and is not a driving force of economic growth

Question 15

Where are these changes in productivity coming from?

Answer 15

• Education: people go longer to school nowadays
- We call this improvements in human capital

• Innovation: new technologies are being invented

Question 16

Innovation and government

Answer 16

• Government plays an important role in innovation
• Institutions (property rights, patents, etc…).
• If a firm cannot patent an innovation, why would it invest money in
innovation?
• Education
• Stability

Question 17

Why are some countries more productive than others?

Answer 17

• Proximate causes (“direct” causes)
• Human capital (could also be reverse causality)
• Technology
• Ultimate causes (“deep” causes)
• Culture: different work ethics
• Institutions: low corruption, property rights, ease of doing business
• Geography: climate, market access (easy transportation), tourism
• …

Question 18

Convergence hypotheses

Answer 18

1. Absolute convergence: relatively poor countries have higher rates of
   growth of real GDP per capita than relatively rich countries

Conditional convergence: poorer countries have higher rates of growth
only when they are similar in terms of other growth determinants

-Conditional convergence seems to hold but absolute convergence
does not

Question 19

Economic growth

Answer 19

• Economic growth is caused by increased productivity
• One option would be that we decide to work less in response to increased productivity
such that GDP per hour worked rises, but GDP per capita stays constant
• -> we could consume the same amount and have more leisure
• -> and because we are more efficient at producing, probably emit less CO2
• However, hours worked per person have only fallen a little bit over time
• It is our choice to keep continuing to work a lot and to consume more
• Recall (that in NL) GDP per capita is about three times as large as in 1960
• If we would decide to work three times as little (e.g., 12 hours instead of 36 hours per
week) we could still consume as much as our grandparents did (while having a 5-day
weekend!)

Question 20

Directed technical change

Answer 20

• Productivity changes are due to new innovations
• What if we can ensure that these innovations lead to cleaner technology?
• For instance, by giving R&D subsidies to clean technologies

Question 21

Optimistic view

Answer 21

• With the right government policies, we can battle climate change without
giving up too much of economic growth

Question 22

Other government policies

Answer 22

• Tax on fuel or tax on CO2 emissions give incentives
• For firms to switch to more energy efficient ways of production
• For households to consume less energy (putting thermostat lower, driving less or
using an electric car)
• This winter/spring energy prices were high. Good from climate
perspective
• But…
• The Dutch and other governments responded by lowering taxes on
energy…

Question 23

Pessimistic view

Answer 23

• If government does not put the right policies in place we will not be able
to handle climate change