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Macroeconomics & The Macroeconomics & The Global EconomyGlobal Economy
Ace Institute of ManagementAce Institute of Management
Chapter 7 and 8: Economic Growth IChapter 7 and 8: Economic Growth I
Instructor
Sandeep Basnyat
9841 892281
CHAPTER 7CHAPTER 7 Economic Growth I Economic Growth I slide 2
The Solow or Neo Classical ModelThe Solow or Neo Classical Model A major paradigm by Robert Solow:
– widely used in policy making– benchmark against which most
recent growth theories are compared
The rate at which the output of the economy grows basically depends on the rate at which the followings grow over time:– Capital Stock– Labour Force– Technological Progress
Factors of Production
- Production Function
CHAPTER 7CHAPTER 7 Economic Growth I Economic Growth I slide 3
The Solow Model- Accumulation of The Solow Model- Accumulation of
Capital Stock in an EconomyCapital Stock in an Economy How much capital an economy can
accumulate depends on:
– supply of goods (Output) : depends on Production function
– demand of goods (Input): depends on Consumption function
CHAPTER 7CHAPTER 7 Economic Growth I Economic Growth I slide 4
The production functionThe production function
In aggregate terms: Y = F (K, L )
Define: y = Output k = Capital Stock L = No. of Labour
Assumption: Constant return to scale. So,zY = F (zK, zL ) for any z > 0
Suppose, z = 1/L. Then, Y/L = F (K/L , 1)Amount of Output per worker (Y/L) is the
function of amount of capital per worker (K/L) .
CHAPTER 7CHAPTER 7 Economic Growth I Economic Growth I slide 5
The production functionThe production function
Assume, Y/L = y and K/L = k. Then,
y = f(k). Ignore ‘1’ as a constant. …(i)
Eqn, (i) shows how much extra output a worker produces given an extra capital (Marginal Product of Capital-MPK).
CHAPTER 7CHAPTER 7 Economic Growth I Economic Growth I slide 6
The production functionThe production functionOutput per worker, y
Capital per worker, k
f(k)
Note: this production function exhibits diminishing MPK.
Note: this production function exhibits diminishing MPK.
1MPK
Note:When capital per worker is high, extra unit of capital produces lower output
Vice Versa.
CHAPTER 7CHAPTER 7 Economic Growth I Economic Growth I slide 7
The Demand for Goods and ServicesThe Demand for Goods and Services
y = c + i (remember, no G : Two Sector)
In “per worker” terms:
Output per worker is divided into consumption per
worker and investment per worker
Since people save and consume their income,
If savings rate = s, then, c = (1-s)
So, fraction of the income that people consume is
c = (1-s)y ….. Consumption Fn.
CHAPTER 7CHAPTER 7 Economic Growth I Economic Growth I slide 8
The Demand for Goods and ServicesThe Demand for Goods and Services
Substituting the value of ‘c’ in y;
y = (1-s)y + i or
i = sy
Shows that investment equals saving
where ‘s’ is the fraction of the output/
income devoted to investment.
CHAPTER 7CHAPTER 7 Economic Growth I Economic Growth I slide 9
Basis of Neo-Classical Growth ModelBasis of Neo-Classical Growth Model
The main building block of the model: production function (Y depends on K, L and the technological progress)
Investment : K
Depreciation : K
So, When I > D; K
When I < D; K
When I = D; K- Unchanged (Steady State)
Big Question: When does investment exceed depreciation, and when does it fall short of it?
CHAPTER 7CHAPTER 7 Economic Growth I Economic Growth I slide 10
Basis of Neo-Classical Growth ModelBasis of Neo-Classical Growth Model
Depreciation: we may safely assume it as a constant (usually shown by 45 degree).
Investment: Can be shown in terms of savings.
Saving is a fixed share of to total income. Therefore, savings and/or investment at different capital stocks can be presented as a part of the total output (Income).
CHAPTER 7CHAPTER 7 Economic Growth I Economic Growth I slide 11
Graphical representation without TechnologyGraphical representation without Technology
Capital Per Worker
Ou
tpu
t P
er W
ork
er
Steady State
CHAPTER 7CHAPTER 7 Economic Growth I Economic Growth I slide 12
The model and increase in the saving rateThe model and increase in the saving rate
Capital Per Worker
Out
put P
er W
orke
r
CHAPTER 7CHAPTER 7 Economic Growth I Economic Growth I slide 13
The model and increase in populationThe model and increase in population
CHAPTER 7CHAPTER 7 Economic Growth I Economic Growth I slide 14
Effect of Technological AdvancementEffect of Technological Advancement
y’ = f(k)
ir = dk
i = s f(k)
k
y
k*
y*i = s' f(k)
k1*
y*’ y = f(k)
•Productivity per worker increases
•Shifts the Production functions upward
•Saving rate shifts upward
•Capital stock per worker increases
•New Steady State is formed
•Output per worker is increased but greater than “k”
CHAPTER 7CHAPTER 7 Economic Growth I Economic Growth I slide 15
Golden Rule Level of CapitalGolden Rule Level of Capital
•Bench mark for highest level of movement of steady state
•The Golden Rule level of capital accumulation is the steady state with the highest level of consumption.
y = f(k)
ir = dk
i = s f(k)
k
y
C*gold
I*gold
k*gold
CHAPTER 7CHAPTER 7 Economic Growth I Economic Growth I slide 16
Policy issues: Policy issues: How to increase the saving rate?How to increase the saving rate?
Reduce the government budget deficit(or increase the budget surplus).
Increase incentives for private saving. Example: Reduce tax
CHAPTER 7CHAPTER 7 Economic Growth I Economic Growth I slide 17
Policy issues: Policy issues: Allocating the economy’s investmentAllocating the economy’s investment
In the Solow model, there’s one type of capital.
In the real world, there are many types,which we can divide into three categories:– private capital stock– public infrastructure– human capital: the knowledge and
skills that workers acquire through education.
How should we allocate investment among these types?
CHAPTER 7CHAPTER 7 Economic Growth I Economic Growth I slide 18
Policy issues: Policy issues: Allocating the economy’s investmentAllocating the economy’s investment
Two viewpoints:
1. Let the market allocate investment to the type with the highest marginal product.
2. Industrial policy by government: Govt should actively encourage investment in capital of certain types or in certain industries, because they may have positive externalities that private investors don’t consider.
CHAPTER 7CHAPTER 7 Economic Growth I Economic Growth I slide 19
Policy issues: Policy issues: Establishing the right institutionsEstablishing the right institutions
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.
CHAPTER 7CHAPTER 7 Economic Growth I Economic Growth I slide 20
Policy issues: Policy issues: Encouraging tech. progressEncouraging tech. progress
Patent laws:encourage innovation by granting temporary monopolies to inventors of new products.
Tax incentives for R&D
Grants to fund basic research at universities
Industrial policy: encourages specific industries that are key for rapid tech. progress