Macroeconomics

N. Gregory Mankiw

Economic Growth
II: Technology,
Empirics, and
Policy

Presentation Slides

© 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

3 The
CHAPTER 9
1 National
Economic
Science
Income
Growth
of Macroeconomics
II
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:
• 1900–2016: U.S. real GDP per person grew by a
factor of 8.58, or 1.9% per year.
• examples of technological progress abound
(see the next slide).
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
2016: 3.4 billion Internet users, 5.0 billion cell phone
users
• 2001: iPod capacity = 5GB, 1,000 songs. Not capable of
playing episodes of Game of Thrones.
2018: iPod touch capacity = 64GB, 30,000 songs. Can
play episodes of Game of Thrones.
Technological progress in the Solow model, part 1

• A new variable: E = labor efficiency

• Assume:
Technological progress is labor-augmenting:
it increases labor efficiency at the exogenous rate g:

ΔE
g=
E
Technological progress in the Solow model, part 2

We now write the production function as:

Y = F ( K, L × E )
 where L × E = number of effective workers
 Increases in labor efficiency have the same effect on
output as increases in the labor force.
Technological progress in the Solow model, part 3

• 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:
s y = s f(k)
Technological progress in the Solow model, part 4

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

Δk = s f(k) − (δ +n +g)k
 Steady-state growth rates in the Solow model with tech.
progress

Variable Symbol Steady-State Growth Rate

Capital per effective worker k = K/(E × L) 0
Output per effective worker y = Y/(E × L) = f(k) 0
Output per worker Y/L = y × E g
Total output Y = y × (E × L) n+g
The Golden Rule with technological progress

To find the Golden Rule capital stock, express c* in terms

of k*:
Growth empirics: Balanced growth

• The Solow model’s steady state exhibits balanced

growth: many variables grow at the same rate.
• The Solow model predicts that Y/L and K/L grow at
the same rate (g), so K/Y should be constant. This is
true in the real world.
• The Solow model predicts that real wage grows at the
same rate as Y/L, while real rental price is constant.
Also true in the real world.
Growth empirics: Convergence, part 1

• 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 and poor
countries would shrink over time, causing living standards
to converge.
• In the real world, many poor countries do NOT grow
faster than rich ones. Does this mean the Solow model
fails?
Growth empirics: Convergence, part 2

• No, the Solow model does not fail because it predicts

that, other things equal, poor countries (with lower Y/L
and K/L) should grow faster than rich ones.
• In samples of countries with similar savings and
population growth rates, income gaps shrink about 2%
per year.
• In larger samples, after controlling for differences in
saving, population growth, and human capital,
incomes converge by about 2% per year.
Growth empirics: Convergence, part 3

• 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.
Growth empirics: Factor accumulation vs. production
efficiency, part 1
• 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.
Growth empirics: Factor accumulation vs. production
efficiency, part 2
• Possible explanations for the correlation between capital
per worker and production 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.
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?
Policy issues: Evaluating the rate of saving, part 1

• 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), the U.S. economy is below the
Golden Rule steady state and should increase s.
• If (MPK − δ) < (n + g), the U.S. economy is above the
Golden Rule steady state and should reduce s.
Policy issues: Evaluating the rate of saving, part 2

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.
Policy issues: Evaluating the rate of saving, part 3

1. k = 2.5 y
2. δk = 0.1 y
3. MPK × k = 0.3 y

To determine δ, divide 2 by 1:

δk 0.1y 0.1
= δ= = 0.04
k 2.5 y 2.5
Policy issues: Evaluating the rate of saving, part 4

1. k = 2.5 y
2. δk = 0.1 y
3. MPK × k = 0.3 y

To determine MPK, divide 3 by 1:

MPK × k 0.3 y 0.3

=  MPK = = 0.12
k 2.5 y 2.5

Hence, MPK − δ = 0.12 − 0.04 = 0.08

Policy issues: Evaluating the rate of saving, part 5

• 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.
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, and
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.
Policy issues: Allocating the economy’s investment, part 1

• 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?
Policy issues: Allocating the economy’s investment, part 2

Two viewpoints:
1. Equalize tax treatment of all types of capital in all
industries and 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 it
may have positive externalities that private investors
don’t consider.
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.
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.
Establishing the right institutions: North versus 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
10 times higher in S. Korea
than in N. Korea.
Policy issues: Encouraging technological 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
technological progress (subject to the preceding
concerns).
CASE STUDY: Is free trade good for economic growth?
Part 1
• Since Adam Smith, economists have argued that free
trade can increase production efficiency and living
standards.
• Research by Sachs & Warner:

Average annual growth rates, 1970–89

Open Closed
Developed nations 2.3% 0.7%
Developing nations 4.5% 0.7%
CASE STUDY: Is free trade good for economic growth?
Part 2
• To determine causation, Frankel and Romer exploit
geographic differences among countries:
• Some nations trade less because they are farther
from other nations or landlocked.
• Such geographic differences are correlated with trade
but not with other determinants of income.
• Hence, they can be used to isolate the impact of trade
on income.
• Findings: increasing trade/GDP by 2% causes GDP per
capita to rise 1%, other things equal.
Endogenous growth theory

• Solow model:
• Sustained growth in living standards is due to
technological progress.
• The rate of technological progress is exogenous.
• Endogenous growth theory:
• In this set of models, the growth rate of productivity
and living standards is endogenous.
Endogenous growth theory

• Solow model:
• Growth rate is affected by k (capital intensity)
• Higher k lowers the growth rate
• Country’s growth rate decreases as k increases;
• Those countries with higher k grows slower

• Endogenous growth theory:

The basic model, part 1

• Production function: Y = A K
where A is the amount of output for each unit of capital
(A is exogenous and constant)
• Key difference between this model and Solow: MPK is
constant here, diminishes in Solow
• Investment: sY
• Depreciation: δK
• Equation of motion for total capital:
• ΔK = sY − δK
The basic model, part 2

ΔK = sY − δK

Divide through by K and use Y = A K to get:

ΔY ΔK
= = sA  δ
Y K

• 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.
Does capital have diminishing returns or not?

• It depends on the definition of capital.

• If capital is narrowly defined (only plant and 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.
A two-sector model, part 1

• Two sectors:
• manufacturing firms produce goods.
• research universities produce knowledge that
increases labor efficiency in manufacturing.
• u = fraction of labor in research (u is exogenous)
• Manufacturing production function:
• Y = F [K, (1 − u )E L]
• Research production function: ΔE = g (u)E
• Capital accumulation: ΔK = s Y − δK
A two-sector model, part 2

• 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 the Solow model)
• u: affects level and growth rate of income
DISCUSSION QUESTION The merits of raising u

Question:

In what ways would raising u (that is, devoting more

labor to research) benefit the economy? What are the
costs of raising u?
Facts about R&D

1. Much research is done by firms seeking profits.

2. Firms profit from research:
Patents create a stream of monopoly profits.
There is extra profit in 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.
Is the private sector doing enough R&D?

• The existence of positive externalities in the creation of

knowledge suggests that the private 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 the government should encourage
R&D.
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 (1811–1812) destroyed machines that
displaced skilled mill workers in England.
• Walmart displaces many mom-and-pop stores.
 CHAPTER SUMMARY, PART 1
• Key results from the Solow model with
technological progress:
 The steady-state growth rate of income per person
depends solely on the exogenous rate of
technological progress.
 The United State has much less capital than the
Golden Rule steady-state level.
• Ways to increase the saving rate:
 increase public saving (reduce budget deficit)
 tax incentives for private saving

3 The
CHAPTER 9
1 National
Economic
Science
Income
Growth
of Macroeconomics
II
 CHAPTER SUMMARY, PART 2
• Empirical studies
 The Solow model explains balanced growth,
conditional convergence.
 Cross-country variation in living standards is
due to differences in capital accumulation and in
production efficiency.
• Endogenous growth theory: Models that
 examine the determinants of the rate of
technological progress, which Solow takes as given.
 explain decisions that determine the creation of
knowledge through R&D.

3 The
CHAPTER 9
1 National
Economic
Science
Income
Growth
of Macroeconomics
II