Economic Growth in the Long Run TOPIC 2 MBA HEC PARIS

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1 Economic Growth in the Long Run TOPIC 2 MBA HEC PARIS

2 The most important (economic) questions What are the sources of growth? What account for cross-country income differences? "Once one starts to think about them, it is hard to think about anything else." Robert Lucas - Nobel Prize in Economics1995 (on economic growth)

3 Long-run economic growth 11 log (GDP Per Capita in 1990 dollars) France UK USA Japan

4 Cross-country income differences United States 55,904 Senegal 935 United States/ Senegal=59.79!

5 Solow Model The Solow Growth Model is one of the benchmark models in macroeconomics. This model highlights one aspect of production: production is the transformation of inputs into output (supply side) The key component of the Solow model is the aggregate production function

6 The Production Function The production function is a mathematical expression that allow us to compute how much output (GDP) can be produced using some inputs The standard version of the model has a production function that only includes two basic inputs: Capital (accumulation of machines, equipment, buildings) and Labor (the number of workers or hours worked in the economy) Y t = A t K t α L t 1 α Y= Output (GDP) K = Capital. L = Labor (Measured as Number of Workers or Total Hours Worked) A = Total Factor Productivity α = Capital Income Share (weight Capital in the Production Function

7 Diminishing Marginal Product Marginal Product: measures the additional output that can be produced by using one more unit of the input keeping the others fixed. Example: Let s assume A=L=1 and the capital share The production function is then: Y t = K t 1 2 α = 1 2 K Y Marginal Product of Capital Output (Y) Capital (K)

8 Perfectly Competitive - Maximizing Framework Let s assume a representative firm that runs an economy-wide production function: max π = AK a L 1 a wl rk L,K The firm will choose Labor and Capital up to the point the Marginal Product of Labor (MPL) is equal to the real wage and the Marginal Product of Capital (MPK) equals the real cost of capital: MPL = ( 1 a )A K L MPK = ( a )A L K 1 a a = w = r

9 Solow Model Y t = AK t a L t 1 a K t+1 = K t ( 1 δ ) + I t I t = sy t C = ( 1 s)y = Y I t t t t

10 Solow Model (per Capita) y t = Y t L t,k t = K t L t,c t = C t L t,i t = I t L t,k t+1 = K t+1 L t+1 y t = Ak a t k t+1 = k t ( 1 δ ) + i t i t = sy t

11 Solow Model (the Role of Capital) Output per Worker (y) Low Capital, Low Output High Capital, High Output y t = Ak a t Capital per Worker (k)

12 Solow Model (the Role of Productivity) Higher TFP, Higher Output Output per Worker (y) y t = Ak a t Capital per Worker (k)

13 Solow Model- Steady State (I) Output Output, Investment, Depreciation Depreciation Investment y t = Ak a t k t+1 = k t 1 δ Capital-Per-Capita (k) ( ) + i i = sy t t t

14 Solow Model- Steady State (II) Output Output, Investment, Depreciation Depreciation Investment Capital-Per-Capita (k) k = sa δ 1 1 a, y = a s 1 1 a A 1 a, i = δ s δ a 1 1 a A 1 1 a

15 Solow Model- Convergence US Output Output, Investment, Depreciation Soviet Union Depreciation Investment Capital-Per-Capita (k)

16 Conditional Convergence High A Output US US Investment US Output, Investment, Depreciation Low A Soviet Union y steady-state Depreciation y steady-state Output Soviet Unoin Investment Soviet Union Capital-Per-Capita (k)

17 Unconditional Convergence in the data Average Growth PNG SLV GUY MUS SUN IRNOMN KOR IRL IDN CYP DNK HND MYS COL JPN SEN BEN CPV ISR ZMB PRT PER YUG VEN SAU TTO PRY ZAF SYR SLE PAN CRI URY ARG GHA GRC SGP LSO TUR JOR MEX HTI CHN CMR PAK DZA DOM CHL BRA COG JAM OAN HUN NIC THA HKG MAR SYC ESP MRT KEN ROM NAM GTM CIV YEM ECU BGD PRI ISL NZL SWE AUT GBR FIN NOR NLD FRA AUS CHE DEU BEL y"="$0.0001x"+"5.5054" R²"=" " ITA CAN LUX USA 0 5,000 10,000 15,000 20,000 25,000 GDP per Capita 1960 (PPP, constant prices of 2005)

18 Cross-country Income differences GDP Per Capita Relative to the US (same TFP as the US) Norway Singapore Spain Switzerland Italy Japan Finland Belgium Denmark Austria Hong Netherlands Ireland Kong Iceland France Germany United States BahrainSouth Cyprus Korea Malta Slovenia Greece Oman United Canada Sweden Kingdom Czech Portugal Taiwan Republic Lebanon Hungary Saudi Arabia Latvia Croatia Estonia Slovakia Israel Turkmenistan Romania Malaysia Argentina Lithuania Russia Poland Bahamas Albania Serbia Saint Belarus Kazakhstan Turkey Chile Kitts and Nevis Thailand Uruguay Brazil Venezuela Maldives Montenegro Iran Mexico Bulgaria Colombia China Ukraine Bhutan Peru Macedonia Mongolia Jordan Suriname Ecuador Antigua and Barbuda Bosnia Dominican Panama and Herzegovina Republic Trinidad Barbados and Tobago Georgia Azerbaijan Costa Rica Vietnam Philippines Moldova Sri Paraguay Syria Indonesia Jamaica Armenia Lanka Grenada Saint Vincent Lucia and the Grenadines Tajikistan Yemen Laos Pakistan Honduras India Bolivia Guatemala Iraq Uzbekistan BelizeDominica Nepal Bangladesh Cambodia Kyrgyzstan El Salvador GDP Per Capita Relative to the US

19 Conditional Convergence Average Growth DNK PRI ISL NZL SWE AUT GBR FIN NORNLD FRA AUS CHE DEU BEL ITA CAN y"="$0.0003x"+"7.7241" R²"=" " LUX USA 0 5,000 10,000 15,000 20,000 25,000 GDP per Capita 1960 (PPP, constant prices of 2005)

20 Convergence Europe = GDP Per Capita US FRA GBR GER GRC ITA ESP

21 Convergence Latin America = GDP Per Capita US ARG BRA CHL COL MEX VEN

22 Convergence Asia = GDP Per Capita US JPN KOR CHN IDN IND

23 Total Factor Productivity Quality of Inputs ( Utilization of Capital, Human Capital) Innovation and R&D (Technology in the broad sense of knowing how to do things) Organizational Capital and Management Practices Institutions (Legal Framework, Regulation, Corruption, Social Norms) Misallocation

24 The Fundamentals of Total Factor Productivity Why some countries have a technological advantage or have better institutions, markets and set of rules? Competing ideas: Luck Geography Institutional Endowment

27 Growth Accounting Y t Y t 1 Y t 1 = A t A t 1 A t 1 + α K t K t 1 K t 1 + ( 1 α ) L t L t 1 L t 1 Output growth= weighted average of capital (K), labor (L) and total factor productivity growth (A)

28 Growth Accounting US vs Soviet Union 10 US 10 Soviet Union TFP (% changes) Labor (% changes) Capital (% changes)

29 Growth Accounting: Spain 6 L K A (% contrubution, 5 year moving average)

30 Growth Accounting: France 6 L K A (% contribution, 5 year moving average)

31 Growth Accounting: US 6 L K A (% contribution, 5 year moving average)

32 Growth Accounting: Japan 16 L K A (% contribution, 5 year moving average)

33 Growth Accounting: China 12 L K A (% contribution, 5 year moving average)

34 Secular Stagnation 4.8 log Quarterly GDP Per Capita (constant US dollars) Q Q Q Q France Germany UK US Why developed economies are growing below historical trend?

35 Secular Stagnation Demography: the population is stagnant, life expectancy is increasing rapidly. Education: the mass education revolution is complete, no further increase in the average US education level is to be expected. Inequality: the raising share of the top 10% of the income distribution has deprived the middle class of income growth since Productivity slow down: marginal changes in innovation relative to the past Lack of demand: the zero lower bound

36 Demographics 30 Young Population as Fraction of total (%) JPN US GER EUROPE

37 Income Inequality in the US Share of total Income Excluding Capital Gains (%) Top 10-5% Top 5-1% Top 1%

38 Average growth rate of TFP in the US by decade Gordon (2015) The Rise and Fall of American Growth: The U.S. Standard of Living since the Civil War

39 TFP adjusted by Capital utilization =

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