Macroeconomics

N. Gregory Mankiw

Economic
Growth II:
Technology,
Empirics, and
Policy

© 2019 Worth Publishers, all rights reserved

 IN THIS CHAPTER, YOU WILL LEARN:

▪ how to incorporate technological progress in the

Solow model
▪ about policies to promote growth
▪ about growth empirics: confronting the theory with
facts
▪ two simple models in which the rate of
technological progress is endogenous

1
 Introduction
In the Solow model of Chapter 8,
▪ the production technology is held constant.
▪ income per capita is constant in the steady
state.
Neither point is true in the real world:
▪ 1900–2013: U.S. real GDP per person grew by
a factor of 8.3, or 1.9% per year.
▪ examples of technological progress abound
(see next slide).

CHAPTER 9 Economic Growth II 2

 Examples of technological progress
▪ U.S. farm sector productivity nearly tripled from 1950 to 2012.
▪ The real price of computer power has fallen an average of
30% per year over the past three decades.
▪ 2000: 361 million Internet users, 740 million cell phone users
2015: 3.1 billion Internet users, 4.9 billion cell phone users
▪ 2001: iPod capacity = 5gb, 1000 songs. Not capable of
playing episodes of Game of Thrones.
2015: iPod touch capacity = 64gb, 16,000 songs. Can play
episodes of Game of Thrones.

CHAPTER 9 Economic Growth II 3

 Technological progress in the Solow
model
▪ A new variable: E = labor efficiency
▪ Assume:
Technological progress is labor-augmenting:
it increases labor efficiency at the exogenous
rate g:

CHAPTER 9 Economic Growth II 4

 Technological progress in the Solow
model
▪ We now write the production function as:
Y = F (K , L  E )
▪ where L × E = the number of effective
workers.
▪ Increases in labor efficiency have the
same effect on output as increases in
the labor force.

CHAPTER 9 Economic Growth II 5

 Technological progress in the Solow
model
▪ Notation:
y = Y/ LE = output per effective worker
k = K / LE = capital per effective worker
▪ Production function per effective worker:
y = f(k)
▪ Saving and investment per effective worker:
sy = sf(k)

CHAPTER 9 Economic Growth II 6

 Technological progress in the Solow
model
(δ + n + g)k = break-even investment:
the amount of investment necessary
to keep k constant.
Consists of:
▪ δ k to replace depreciating capital
▪ nk to provide capital for new workers
▪ gk to provide capital for the new “effective”
workers created by technological progress

CHAPTER 9 Economic Growth II 7

 Technological progress in the Solow
model
Investment, Δk = s f(k) − (δ +n +g)k
break-even
investment
(δ+n +g ) k

sf(k)

k* Capital per
effective worker, k
CHAPTER 9 Economic Growth II 8
 Steady-state growth rates in the
Solow model with tech. progress
Steady-state
Variable Symbol
growth rate
Capital per
k = K / (L × E ) 0
effective worker
Output per
y = Y / (L × E ) 0
effective worker

Output per worker (Y/L) = y × E g

Total output Y = y×E×L n+g

CHAPTER 9 Economic Growth II 9

 The Golden Rule with technological
progress
To find the Golden Rule capital stock,
express c* in terms of k*:
In the Golden
*
c = y * − i *
Rule steady state,
= f (k*) − (δ +n +g) k* the marginal
product of capital
c* is maximized when
net of depreciation
MPK = δ + n +g equals the
or equivalently, pop. growth rate
plus the rate of
MPK − δ = n + g
tech progress.

CHAPTER 9 Economic Growth II 10

 Growth empirics: Balanced growth
▪ 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.

CHAPTER 9 Economic Growth II 11

 Growth empirics: Convergence

▪ 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?

CHAPTER 9 Economic Growth II 12

 Growth empirics: Convergence

▪ Solow model predicts that, other things equal,

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.
CHAPTER 9 Economic Growth II 13
 Growth empirics: Convergence

▪ 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.
▪ This prediction comes true in the real world.

CHAPTER 9 Economic Growth II 14

 Growth empirics: Convergence

Figure 1 Figure 2

7 7
6 6

Growth rate: 1960&1985

Growth rate: 1960&1985

5 5
4 4
3 3
2 2
1 1
0 0
&1 &
&2 1
5.5 6.5 7.5 8.5 9.5 & 5.5 6.5 7.5 8.5 9.5
Log output per working-age adult: 1960 2 Log output per working-age adult: 1960

Source: Figures 1 and 2: G. Mankiw, D. Romer, and D. Weil, “A Contribution to the Empirics of Economic Growth,” Quarterly Journal of Economics
107, no. 2 (May 1992): 407–38.

See Supplement 9-1.

CHAPTER 9 Economic Growth II 15

 Growth empirics: Convergence
Figure 1 Per Capita Personal Income as a Percentage of U.S. Average By Region
160
Mideast Far West

140
New England
Great
120
Lakes

100 Plains Rocky Mt.

80
Southwest

Southeast
60

40

Source: U.S. Department of Commerce, Bureau of Economic Analysis.

See Supplement 9-2.

CHAPTER 9 Economic Growth II 16
 Growth empirics: Factor accumulation
vs. production efficiency
▪ Differences in income per capita among countries
can be due to differences in:
1. capital—physical or human—per worker
2. the efficiency of production
(the height of the production function)
▪ Studies:
▪ Both factors are important.
▪ The two factors are correlated: countries with
higher physical or human capital per worker also
tend to have higher production efficiency.
CHAPTER 9 Economic Growth II 17
 Growth empirics: Factor accumulation
vs. production efficiency
▪ Possible explanations for the correlation
between capital per worker andproduction
efficiency:
▪ Production efficiency encourages capital
accumulation.
▪ Capital accumulation has externalities that
raise efficiency.
▪ A third, unknown variable causes
capital accumulation and efficiency to be
higher in some countries than others.
CHAPTER 9 Economic Growth II 18
 Policy issues
▪ Are we saving enough? Too much?
▪ What policies might change the saving rate?
▪ How should we allocate our investment
between privately owned physical capital,
public infrastructure, and human capital?
▪ How do a country’s institutions affect production
efficiency and capital accumulation?
▪ What policies might encourage faster
technological progress?

CHAPTER 9 Economic Growth II 19

 Policy issues:
Evaluating the rate of saving
▪ Use the Golden Rule to determine whether
the U.S. saving rate and capital stock are
too high, too low, or about right.
▪ If (MPK − δ) > (n + g ),
U.S. economy is below the Golden Rule steady
state and should increase s.
▪ If (MPK − δ) < (n + g ),
U.S. economy is above the Golden Rule steady
state and should reduce s.

CHAPTER 9 Economic Growth II 20

 Policy issues:
Evaluating the rate of saving
To estimate (MPK − δ), use three facts about the
U.S. economy:
1. k = 2.5 y
The capital stock is about 2.5 times one year’s
GDP.
2. δk = 0.1 y
About 10% of GDP is used to replace depreciating
capital.
3. MPK × k = 0.3 y
Capital income is about 30% of GDP.
CHAPTER 9 Economic Growth II 21
 Policy issues:
Evaluating the rate of saving
1. k = 2.5 y
2. δk = 0.1 y
3. MPK × k = 0.3 y

To determine δ, divide 2 by 1:

  = 0.1
= 0.04
2.5

CHAPTER 9 Economic Growth II 22

 Policy issues:
Evaluating the rate of saving
1. k = 2.5 y
2. δk = 0.1 y
3. MPK × k = 0.3 y

To determine MPK, divide 3 by 1:

 MPK =
0.3
= 0.12
2.5

Hence, MPK − δ = 0.12 − 0.04 = 0.08

CHAPTER 9 Economic Growth II 23

 Policy issues:
Evaluating the rate of saving
▪ From the last slide: MPK − δ = 0.08
▪ U.S. real GDP grows an average of 3% per year,
so n + g = 0.03
▪ Thus,
MPK − δ = 0.08 > 0.03 = n + g
▪ Conclusion:
The U.S. is below the Golden Rule steady state:
Increasing the U.S. saving rate would increase
consumption per capita in the long run.
CHAPTER 9 Economic Growth II 24
 Policy issues:
How to increase the saving rate
▪ Reduce the government budget deficit
(or increase the budget surplus).
▪ Increase incentives for private saving:
▪ Reduce capital gains tax, corporate income tax,
estate tax, as they discourage saving.
▪ Replace federal income tax with a consumption
tax.
▪ Expand tax incentives for IRAs (individual
retirement accounts) and other retirement
savings accounts.

CHAPTER 9 Economic Growth II 25

 Policy issues:
Allocating 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 9 Economic Growth II 26

 Policy issues:
Allocating the economy’s investment
Two viewpoints:
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:
Government 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 9 Economic Growth II 27

 Possible problems with
industrial policy

▪ The government may not have the ability to “pick

winners” (choose industries with the highest return
to capital or biggest externalities).
▪ Politics (e.g., campaign contributions) rather than
economics may influence which industries get
preferential treatment.

CHAPTER 9 Economic Growth II 28

 Policy issues:
Establishing 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 9 Economic Growth II 29

 Establishing the right institutions:
North vs. South Korea

After WW2, Korea split into:

▪ North Korea with
institutions based on
authoritarian communism
▪ South Korea with
Western-style democratic
capitalism
Today, GDP per capita is
over 10x higher in S. Korea
than N. Korea

CHAPTER 9 Economic Growth II 30

 Establishing the right institutions:
Corruption and Growth

CHAPTER 9 Economic Growth II See Supplement 9-5 31

 Policy issues:
Encouraging tech. progress
▪ Patent laws:
encourage innovation by grantingtemporary
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
(subject to the preceding concerns).

CHAPTER 9 Economic Growth II 32

 Endogenous growth theory
▪ Solow model:
▪ sustained growth in living standards is due to
tech progress.
▪ the rate of tech progress is exogenous.
▪ Endogenous growth theory:
▪ a set of models in which the growth rate of
productivity and living standards is
endogenous.

CHAPTER 9 Economic Growth II 35

 The basic model
▪ Production function: Y = AK
where A is the amount of output for each
unit of capital (A is exogenous& constant)
▪ Key difference between this model & Solow:
MPK is constant here, diminishes in Solow
▪ Investment: sY
▪ Depreciation: δK
▪ Equation of motion for total capital:
ΔK = sY − δK
CHAPTER 9 Economic Growth II 36
 The basic model
ΔK = sY − δK
▪ Divide through by K and use Y = A K to get:

= sA − 

▪ If s A> δ, then income will grow forever,

and investment is the “engine of growth.”
▪ Here, the permanent growth rate depends
on s. In Solow model, it does not.

CHAPTER 9 Economic Growth II 37

 Does capital have diminishing returns
or not?
▪ Depends on 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.

CHAPTER 9 Economic Growth II 38

 A two-sector model
▪ Two sectors:
▪ manufacturing firms produce goods.
▪ research universities produce knowledge that
increases labor efficiencyin manufacturing.
▪ u = fraction of labor in research
(u is exogenous)
▪ Manufacturing: Y = F [K, (1 − u)EL]
▪ Research: ΔE = g (u)E
▪ Capital accumulation: ΔK = sY − δK
CHAPTER 9 Economic Growth II 39
 A two-sector model

▪ In the steady state, manufacturing output per

worker and the standard of living grow at
rate ΔE / E = g (u ).
▪ Key variables:
s: affects the level of income, but not its
growth rate (same as in Solow model)
u: affects level and growth rate of income

CHAPTER 9 Economic Growth II 40

 Facts about R&D
1. Much research is doneby firms seeking profits.
2. Firms profit from research:
▪ Patents create a stream of monopoly profits.
▪ Extra profit from being first 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 technological progress.
CHAPTER 9 Economic Growth II 41
 Is the private sector doing enough
R&D?

▪ The existence of positive externalities in the

creation of knowledge suggests that theprivate
sector is not doing enough R&D.
▪ But, there is much duplication of R&D effort
among competing firms.
▪ Estimates:
Social return to R&D ≥ 40% per year.
▪ Thus, many believe govt should encourage R&D.

CHAPTER 9 Economic Growth II 42

 Economic growth as “creative
destruction”
▪ 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.
CHAPTER 9 Economic Growth II 43