Week 11 - Growth policy Flashcards
What does the slope of the production function in Solow growth model represent?
Marginal product of capital (MPK) - the extra output a worker produces with an extra unit of capital
MPK is diminishing. Capital becomes less useful when you already have lots of it
Investment is a ___ of output. What is the “relationship” between the investment function & production function?
Note: investment = savings
Investment is a FIXED FRACTION of output.
1. Investment function always lies below the production function
Similarities
2. Upward-sloping: an increase in capital per worker increases output p.w.
3. Diminishing MPK causes the slope to decrease as k increases
The change in the capital stock depends on the balance of which 2 effects?
- If investment > depreciation, capital increases
- If investment < depreciation, capital decreases
The dominating effect depends on the current level of capital stock
Why do poor countries grow faster than rich countries?
How do poor countries catch up to income levels of rich countries?
- Lower starting point k (capital per worker) which is MORE PRODUCTIVE due to DIMINISHING MPK
- An extra unit of capital yields a large increase in output, generating a large increase in savings
- Investment HUGELY outstrips depreciation
- Hence, HIGHER RATE of capital accumulation & therefore income grows faster (faster economic growth)
» so China is not an “economic miracle”; it was simply at a lower starting point
^This process is known as convergence.
All countries end up at the same STEADY-STATE LEVEL OF CAPITAL PER WORKER k* no matter where they started.
- where investment = depreciation (we only get replacement investment)
- economy reaches LONG-RUN EQUILIBRIUM
- Solow model predicts that ECONOMIC GROWTH stops in the LONG RUN.
Absolute vs conditional convergence - Why is this relationship not borne out by real world evidence?
Absolute convergence
1. Solow model predicts that poor countries grow faster than rich countries
2. But this is not borne out by real world evidence
- Poor countries do not always grow faster than rich countries due to INSTITUTIONAL DIFFERENCES
eg. poor system of property rights or political instability
Conditional convergence
1. For countries with SIMILAR INSTITUTIONAL FRAMEWORKS, eg. legal system, political stability, competitive markets,
2. poor countries do grow faster than rich countries
Another possible explanation for observed income disparities is differences in savings rates.
What happens if savings rate increases?
- the investment function shifts up, intersection point shifts up
- investment now outstrips depreciation
- steady state level of capital increases
- income per worker also increases
Based on the Solow model, a higher savings rate is associated with a higher long run income level. (An economy with high savings rate trades off lower short run consumption for higher long run consumption.)
But an increase in savings rate does NOT generate long run growth. So what is the engine of growth in the long run?
TECHNOLOGICAL PROGRESS
= Innovations which increase the productivity of labour and capital inputs
1. production function shifts up & hence investment function shifts up.
2. Steady state level of capital increases
3. steady state level of output per worker increases
→ LONG RUN ECONOMIC GROWTH
“Can opener” assumption
Solow model assumes TECHNOLOGICAL PROGRESS appears out of nowhere, and cannot answer questions eg. where it comes from, why is it higher for some countries than others, what is the role of policy
Endogenous growth theory
^explains the source of long run growth
- CAPITAL STOCK is broadened to include KNOWLEDGE, accumulated through R&D activity and scientific discovery.
- This is important b/c knowledge creation exhibits a +VE PRODUCTION EXTERNALITY ← occurs when one firm’s production benefits other firms.
- Due to knowledge spillovers, capital no longer suffers from diminishing marginal productivity.
2 types of capital
- Physical capital (exhibits DIMINISHING marginal returns)
- Knowlege capital (INCREASING marginal returns)
» The diminishing & increasing effects exactly offset each other, hence the production function & investment function become straight lines
- INVESTMENT FUNCTION now has a CONSTANT GRADIENT & always lies ABOVE the depreciation function.
- NO STEADY STATE & capital and output continue to grow in the long run.
What can policy do to increase income levels and growth rates in the Endogenous growth theory?
A framework of intellectual property (IP) rights creates incentives to encourage R&D activity and boost innovation:
- patents give inventors of new products a temporary monopoly, to prevent other firms from copying
- so they can recoup their investment costs
- other firms can pay to use their idea
- but to patent an idea, investors must publish their ideas to make sure it hasn’t been done before
- but this risks INTELLECTUAL PROPERTY THEFT in less lawful countries
Is IP enforcement even a good thing?
2 ways of government intervention to prevent under-investment in R&D activity + what the govt should not do
Trade-off is that it prevents knowledge spillovers, the source of long run growth.
- TAX BREAKS for firms engaging in R&D
- INDUSTRIAL POLICY - govt promotion of high-tech industries
- NOT a trade war
Suppose the economy’s depreciation rate of capital per worker decreases. What are the effects on the long
run level and long run growth rate of income per worker?
- A decrease in the depreciation rate tilts the depreciation function downwards, such that investment
exceeds depreciation at the economy’s original capital stock. - This net investment means that the capital stock increases until the economy converges to a higher steady state capital stock p.w., where income p.w. is also higher.
- But at steady state, investment equals depreciation hence the capital stock stops changing
and hence in the long run there is no growth in income p.w.
