Economics 2 — Semester 1 — Tutorial Sheet 6

Capital Accumulation and Growth

Required reading
- Recent lecture notes
- Nils Gottfries, Macroeconomics, Chapter 5
(Note: it is assumed here and will be assumed in the exam that you are familiar with the
terminology laid out on pages xxvi - xxvii of Gottfries’ text.)

Homework
- Submission of homework this semester works like Econ 1.
- The submission must be done via Learn by 5pm on the Sunday before the tutorials occur.
- The written homework, as before, should be equivalent to at least two sides of
handwritten A4 and should be clear enough to read. Again, it does not need to be
complete, and indeed it does not even need to be correct. You just need to show that you
have made an honest attempt. As long as you have shown an honest attempt, you will get
credit, and as long as you do this for 14 of the 18 tutorials during the year, you will get
full credit.

Further resources
- Gottfries on YouTube: the textbook author (Nils Gottfries) has put 15-40 minute videos
from most chapters of the book on YouTube:
o https://goo.gl/Wq8o82

- FRED: Most of the tutorial sheets this semester contain graphs generated by the St. Louis
Fed’s Federal Reserve Economic Data (FRED) site. This is a surprisingly easy-to-use, free
site for exploring hundreds of thousands of economic data series. You are strongly
encouraged to visit the site whenever you feel the need to find out what’s happened lately
to GDP growth, or inflation, or infant mortality, etc.
o http://research.stlouisfed.org/fred2/

Recordings:
- Questions marked with an asterisk* have video solutions recorded by Sean, which will be
released after the Sunday 5pm submission deadline. Because the asterisk questions are
covered in video, they will mostly not be covered within the tutorials themselves.
 Looking at the data
Using FRED (or another data source) find and print a graph of GDP growth and the growth
of PPP-adjusted GDP per capita for a country of your choice. Include comments on any
trends or features in the data and bring the printed graph and comments to your tutorial.

Priority Questions
We strongly recommend attempting every question on this tutorial sheet. However, if you find yourself
lacking for time and need to prioritize, you should start by focusing on: Q3, Q4, Q5, Q11, and Q15

Tutorial Questions
Q1. Long run growth rates.1

(a) In 1820, per capita income was pretty similar in Jamaica, Brazil and Japan – it was
about £700 per person per year. By 2010, per capita income had risen to about
£3600 in Jamaica, £7 000 in Brazil and £22 000 in Japan. What was the average
growth rate in each country over the time period?

(b) In 1870, Italy had roughly twice the GDP per capita of Hong Kong (£1500 vs. £700).
But by 2010, the positions had almost totally reversed – Hong Kong was about 50%
wealthier than Italy (£30 000 vs. £19 000). What was the average growth rate in each
country over the time period?

𝟏 𝟐
Q2. Returns to scale. Let the production function be 𝒀 = 𝑲𝟑 (𝑬𝑵)𝟑

(a) What will production and production per capita be if 𝑲 = 𝟖, 𝑬 = 𝟏 and 𝑵 = 𝟐𝟕?

(b) What will production and production per capita be if 𝑲 = 𝟏𝟔, 𝑬 = 𝟏 and 𝑵 = 𝟓𝟒?

(c) Compare the answers and explain.

Q3. Shocks to the steady state. Illustrate the effects on the steady state capital stock of the
following shocks and explain the results:

(a) An increase in the depreciation rate.

(b) An increase in the mark-up.

(c) Consumers become more impatient.

Q4. The effects of capital destruction. Consider a country that has no population growth and
where there is no technological development. The capital stock is on the steady state level.
Then there is a large earthquake which destroys 15% of the capital stock and kills 5% of
the population.

(a) Illustrate what happens in a diagram (with the capital stock on the horizontal axis,
and the real rate of return on the vertical axis). What is the long-run effect on the
capital stock and production?

(b) Draw diagrams with time on the horizontal axis to illustrate what happens over time
with the capital stock, investment, the real interest rate, and production.

1 1 The GDP numbers quoted in this question are rounded from Angus Maddison’s historical database (The
Maddison-Project, http://www.ggdc.net/maddison/maddison-project/home.htm, 2013 version), converted from
1990$ to current £ at a 1:1 exchange rate, which is pretty close (the numbers are rough anyway).
Q5. Regulating the work week. The people of the Hexagon seem to like to solve their
problems with government regulation (unlike the people of the Pentagon, who seem to like
to solve their problems with markets).

The Hexagonians decide at some point to introduce a set of laws to shorten the working
week by limiting the number of hours that a person can work per. The new regulations end
up reducing the number of hours worked per capita by 10 percent.

We can model this by using a version of the production function 𝒀 = (𝑲, 𝑬𝑯𝑵), where 𝑯 is
hours worked, and the other variables are as they were before.

(a) What is the condition determining the steady state capital stock per effective worker given
our new production function?

(b) How is the steady state capital stock affected by the change in regulation if the
natural rate of unemployment remains unchanged?

(c) Suppose that Hexagonia has no population growth, and no technological

development. The capital stock is initially at the steady state level. Draw diagrams
with time on the horizontal axis to illustrate what happens over time with the
capital stock, investment, the real interest rate, and production after the reduction
in working time.

Q6. Comparing labour shocks. Using a Cobb-Douglas production function with capital’s share
at 1/3, calculate the effect of the following shocks to the labour market.

(a) An intensive training programme makes workers 5% more efficient (so it is as if we

had 5% more workers). How will this affect aggregate GDP in the short and the long
run? What about output per capita?

(b) Sudden immigration increases the labour force by 5%. How will this affect the
aggregate capital stock and aggregate production in the short and the long run?
What about output per capita?

Q7. Population growth and returns to scale. In the growth model that we have discussed,
population growth leads to steady-state growth in total output, but not in output per
worker. Do you think this would still be true if the production function exhibited increasing
or decreasing returns to scale? Explain.

Q8. r in a growing economy. According to the theory presented in the textbook, there should be a
higher real return on loans in a growing economy. Explain this result.
* Q9. Variance of growth rates. According to Fig. 5.15 (reproduced below), there is much
higher dispersion of growth rates among poor countries than among high-income
countries. What could be the reasons?

* Q10. Depreciation. Suppose that there was no depreciation of capital. How would this
affect…

(a) …the levels of the capital stock and production?

(b) …the growth rates of the capital stock and production?

* Q11. Taxing capital.

(a) Consider an economy in a long-run equilibrium. Write down general the first-order
condition (Euler equation) for consumption and explain it.

(b) Find an expression for the long-run real interest rate if the utility function is the natural
log function (𝑪𝒕) = 𝐥(𝑪𝒕) and if technology grows at the rate 𝒈.

(c) What will the real interest rate be if 𝝆 = 𝟎. 𝟎𝟑 and 𝒈 = 𝟎. 𝟎𝟑?

(d) Suppose that the real net return on capital (𝒓) is taxed at the rate 𝑟. How will this affect the
required return on investment?

(e) What will the real interest rate be if 𝝆 = 𝟎. 𝟎𝟑, 𝒈 = 𝟎. 𝟎𝟑, and 𝑟 = 𝟎. 𝟑?

(f) What will the real interest rate be if 𝝆 = 𝟎. 𝟎𝟑, 𝒈 = 𝟎. 𝟎𝟑, and 𝑟 = 𝟎. 𝟓?

(g) What is the effect on the real interest rate before tax and the steady state capital stock of
an increase in the tax on interest income?

(h) Illustrate the effects of the capital tax on the capital stock. What will happen to output per
worker?
* Q12. Quantifying the effects of capital taxation.

(a) In the textbook, the following expression is given for the steady-state level of
production per person in the labour force (𝒀/𝑳) as a function of 𝑎, 𝝁, 𝒓,̅ 𝜹, 𝑬 and 𝒖:

𝜶
𝒀 𝜶 𝟏−𝜶
=( ) × 𝑬 × (𝟏 − 𝒖)
𝑳 (𝟏 + 𝝁)(𝒓̅ + 𝜹)

Using this expression, assume 𝑎 = 𝟏/𝟑, 𝝁 = 𝟎. 𝟏, 𝜹 = 𝟎. 𝟎𝟔, 𝑬 = 𝟏𝟎𝟎𝟎, and 𝒖 = 𝟎. 𝟏 and

calculate the steady state production per person for 𝒓̅ = 𝟎. 𝟎𝟔, 𝒓̅ = 𝟎. 𝟎𝟗, and
𝒓̅ = 𝟎. 𝟏𝟐.

(b) Comment on the result – are the differences in output per person in part (a) large or
small relative to the kinds of differences that we observe in the real world between
rich and poor countries?

* Q13. Evaluating capital taxation. In view of your answers to the previous two questions, is it a
good idea to tax capital income?

* Q14. Capital-output ratios in poor countries. As seen in the figure2 below (the data are also
available in your textbook in Table 5.1, and in Hsieh & Klenow’s 2010 paper), most poor
countries have a low level of capital relative to income. Why is this? Discuss this question
with the help of the equation for K/Y in the text.

2 Hsieh,
Chang-Tai, and Peter J. Klenow. 2010. "Development Accounting." American Economic Journal:
Macroeconomics, 2(1): 207-23.
* Q15. Growth and the mark-up. Given the formula that you found above for steady state
income per capita, what is the implied relationship between income and the degree of
competitiveness? Should governments always want to drive mark-ups to zero? Can you
think of any reasons why mark-ups might actually be good for long run income growth?

Q16. Convergence. Read the Bloomberg Opinion piece “Why the Developing World Started
Gaining on the West3” by Noah Smith. Noah tells a story about convergence which divides
the past 150 years into three eras – what are they and how are they different? What
explanation is given for the different patterns of convergence in the “middle” era compared
to the latest era? What do you agree or disagree with in the article?

3 https://www.bloomberg.com/opinion/articles/2018-10-18/why-the-developing-world-started-gaining-on-the-west
Why the Developing World Started Gaining
on the West
By Noah Smith
October 18, 2018

During the past three decades, there has been a momentous change in the global economy.
One of the most troubling and puzzling features — the failure of poor countries to catch up
to developed countries — has seemingly been overturned.

Basic growth theory says that developing countries should grow faster than rich ones. One
reason is that capital has diminishing returns — as you build more offices, more houses,
more cars and machine tools and computers — the economic benefit of building yet more of
those things goes down, even as the cost of maintaining them goes up. Second, poor
countries can grow fast by copying technology and business practices from rich countries,
which is almost always cheaper and easier than inventing new technologies and business
practices from scratch.

But, as so often happens in economics, reality has often failed to behave as theory predicts.
Economist Lant Pritchett has documented that between 1870 and 1990, inequality between
countries soared, with Europe, Japan, the U.S. and a few other countries pulling away from
the pack. Of course, much of that divergence was probably due to the impact of colonialism
— it’s hard for a country to get rich when it’s under the thumb of another country. But even
after decolonization, poor countries struggled to catch up for several decades. Economists
Robert Barro and Xavier Sala-i-Martin found that between 1960 and 1985, poor countries
continued to lose ground relative to rich ones.

So was growth theory simply wrong? Maybe. All growth theories contain a fudge factor
representing a nation’s fundamental capacity for productivity — the education of its
populace, the quality of its political institutions, war, damaging government interventions
and so on. Controlling for measures of these things, Barro and Sala-i-Martin found that
developing nations had tended to catch up — the problem was that too many poor countries
fell into civil war or embraced communism or failed to educate their burgeoning
populations, degrading the institutions needed to sustain growth. Economists settled on the
uncomfortable idea that most poor countries didn’t have what it takes, politically, to grow.

Then something amazing happened. Shortly after Barro and Salai-Martin’s 1992 landmark
paper, the story of global growth seemed to change. Many poor countries languished in the
1990s due to low resource prices (poor countries are often natural resource exporters).
China, which had been slowly making up lost ground since the end of Mao Zedong’s rule in
the 1970s, saw its growth accelerate in the 1990s. India and Indonesia also started to catch
up, thanks in part to their own economic reforms.
These countries were so large — together accounting for almost 40 percent of the world’s
population — that their growth began to drive down global inequality:

Meanwhile, the divergence documented by Barro and Sala-i-Martin was reversing.

Beginning in the 1990s, developing countries started to grow faster than developed ones.
Outside of Africa — where a series of bloody wars sent a number of countries into chaos in
the 1990s — the pattern was even stronger.
In the 2000s, commodities prices rebounded, and natural-resource exporting countries began
to share in the new wave of global growth. Meanwhile, China accelerated yet again,
following its entry into the World Trade Organization in 2001 and a burst of productivity
growth. The gap between sprinting developing and slow-growth developed countries
became even greater.

Then came the Great Recession. Rich countries and poor countries alike were hit hard by the
global financial crisis, but — unlike in previous downturns — the poor countries didn’t
suffer more. Catch-up continued. Global inequality kept falling.

Now, a decade after the crisis, economists are starting to reevaluate their long-held beliefs
about global convergence. Dev Patel, Justin Sandefur and Arvind Subramanian of the Center
for Global Development recently looked at multiple datasets on per- capita incomes around
the world, and found that no matter which measure is used, the relationship between starting
income and subsequent growth has been negative since around 1990.

In other words, the idea that rich countries grow more slowly has gone from fiction to fact.
No longer do textbook economic theories need to be fudged — reality has caught up. It
appears that the war, bad policies, and dysfunctional institutions that afflicted developing
nations in the mid- 20th century were a temporary phenomenon.

And the implications for the world are enormous. With economic clout comes geopolitical
heft — the influence of the old colonial powers will steadily diminish, while their ex-
colonies assume more global leadership. Some countries will even make the leap from
developing to developed status, as South Korea has already done. Trade between emerging
markets will continue to increase, bypassing the rich economies entirely.

But most of all, the world will simply be a more equal place. Gone are the days when a few
countries could lord it over others, secure in the illusion that their society had a secret sauce
that others could never emulate.

Source: Bloomberg