SPP 556 Macroeconomics Final Project The future of the Korea Economy The Impact of Low Fertility Rate on Economic Growth

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1 SPP 556 Macroeconomics Final Project The future of the Korea Economy The Impact of Low Fertility Rate on Economic Growth Sehwa Lee, Taizo Suzuki, Wen-Ching Chuang 1

2 I. An Overview of South Korean Economic Trends South Korea is the 10 th largest economy in the world as of 2005 in terms of nominal GDP 1. While it was hit by a financial crisis in 1997, its economy quickly recovered from the shock in the second half of 1998 and gathered momentum in GDP per capita ($, current prices) (Source: IMF World Economic Outlook Database, 2007) Excepting a downturn period between 1997 and 1998, during the financial crisis, Korea s GDP per capita has gradually increased from $12,249 in 1996 to $16,307 in Real GDP growth rate (%) (Source: IMF World Economic Outlook Database, 2007) Though the crisis caused GDP growth rates to plunge to -6.7% in 1998, the real GDP growth rate has averaged 4.5% for the last ten years. By the second half of 1999, the economy had begun to recover, and GDP growth hit 9.5% in 1999 and 8.5% in In the last three years, Korea s growth has been moderate around 4%. 1 US Department of State, IMF,

3 Annual percent change Inflation (Source: IMF World Economic Outlook Database, 2007) As for inflation, it soared up by 7.5% in 1998 during the crisis, but soon fell to 0.8% in Since then, the average inflation rate in Korea has been 3.2% Unemployment rate (%) (Source: IMF World Economic Outlook Database, 2007) As for unemployment, South Korea enjoyed very low unemployment before the crisis, with a rate around 2%. However, it sharply surged to 7% in 1998 and 6.6% in From the second half of 1999, unemployment decreased in 2002, the rate reached at 3.3%. In the past three years, the average unemployment rate has been 3.7%. In sum, the Korean economy has shown a quite robust performance over the last 10 years. II. Future Challenges for the South Korean Economy 3

4 Generally speaking, the South Korean economy has been healthy after the Asian financial crisis. However, we found that the trend of GDP growth has been decreasing since Also, according to the EIU forecast, the GDP growth is expected to decrease in long run. GDP Growth Rate(%) (Source: The EIU Country Data, 2007) At the same time, we notice that South Korea has an unusual low fertility rate, and the rate of population growth is decreasing as well. In 2005, the total fertility rate in Korea was at about 1.08, which ranked below the top 200 countries/regions in the world. In addition, the rate continues to rapidly decrease. This declining, quite low fertility rate is directly related to the population growth rate in the country. Though the population has dramatically increased from 32 million in 1970 to 48 million in 2005, the population growth rate has been continuously declining for more than 20 years. Forecast predicts the population growth rate reach 0 by Total fertility rate total fertility rate (Source: National Statistical Office of Korea, 2007) 4

5 South Korea Population Growth (%) Source (Source: The EIU Country Data, 2007) Therefore, our interest here is What the impact of low population on economy in long run? By using the Solow model, we will explain how the low population growth rates impact the long term growth rate and the level of the standard living in the Korean Society, then provide some possible policy options. III. Analysis Under the Solow growth model, the population growth has an important role in deciding the long term growth rate and the level of the standard of living in a society. In this section, using the basic implications of the model, we predict what will be the future of a country like Korea, which has been facing an unprecedented rapidly decline in its population growth rate. 1) Long term growth rate At the steady state, the amount of capital per worker (k * ) is stable; the amount which is accumulated by investment and the amount which is lost through depreciation and population growth are balanced. At this level, k *, and thus f (k * ) = y * do not change over time. Therefore, the growth rate of income per worker is zero 3 at the steady state, regardless of the society s population growth rate (n) in the society. On the other hand, the 3 Here we do not consider technological advancement. 5

6 growth rate of national income (Y * ) increases 100n % per year 4. If we put continuous technological advancement (g per year) into the model, both income per worker and national income grow at 100g % and 100(n + g) % per year respectively. The Solow growth model sheds light on the relationship between population growth and long term economic growth. First, the growth rate of GDP depends on population growth rate. Regardless of whether we take account of technological advancement or not, a larger population growth rate leads to higher growth rate of GDP, while a smaller population growth rate leads to lower economic growth at the steady state. On the other hand, the population growth rate has nothing to do with the growth rate of income per worker at the steady state. The income per worker grows regardless of the population growth rate depending on the rate of technological changes. In this sense, the population growth rate does not affect in the level of standard of living at the steady state. The forecasts of steady state growth rate in Korea are as follows 56 : Population growth rate (n) % GDP growth rate (real) % technological progress (g) % Stedy State Growth Rate of Y Steady State Growth Rate of Y/worker It is worth noting, however, that population growth rate still has an indirect impact on the growth of the standard of living. As is easily predictable, the changes in population growth and fertility rate are closely correlated with other demographic changes. For example, according to the NSO, the proportion of elderly (population aged over 65) is expected to increase from 9.1% in 2005 to 38.2% in The dependency ratio (the share of population aged over 65 to population aged between 15 and 64) is also projected to rise; 12.6% in 2005 to 21.7% in 2020, to 70% in As Y * = (y * )* (# of workers), % Y * = % y * + % (# of workers) 5 Throughout this paper, we use notations in the tables as follows; Black number; reported and forecast by EIU country Data Italic number; we assume the technology growth is constant. Number with underline; we figure them out through calculations. 6 We use a formula g = GDP growth rate n to figure out g. Also, we assume g is constant at 2005 level in the future. 6

7 Proportion of the elderly over 65 (%) Proportion of the elderly and Dependency ratio Proportion of the elderly over 65 Dependency ratio (Aged) Dependency ratio (aged) (%) (Source: National Statistical Office (NSO) of Korea, 2007) labor force/population (%) (Source: The EIU Country Data, 2007) Along with longer life expectancy, these demographic changes would bring about a relatively smaller share of workers in the society, which will have an adverse effect on the growth rate of income per population 7. 2) Level of standard of living The other consequence of low fertility rate is a decreasing population growth rate. Under the Solow growth model, the steady state of capital per worker moves as the population growth rate changes. There are two scenarios here. First, if other things are all equal, the 7 As (Y * /population) = (Y * /worker) * (worker/population), % Y * /population= % y * + % (worker / population). 7

8 lower population growth rate brings about another steady state with higher capital per worker. investment depreciation (n 1 +δ)k (n 2 +δ)k sf(k) k 1 k 2 capital per worker (k) This shift seems to have a positive effect on the standard of living in society. Higher capital per worker leads to a higher income per worker, as f (k * ) = y *. At the same time, however, the productivity of labor in the society diminishes as capital per worker gets bigger. Under the prevailing assumption of diminishing marginal return on capital about the production function, additional capital per worker has a smaller effect on production when the level of capital per worker is high. investment depreciation MPK 2 f(k) MPK 1 sf(k) k 1 k 2 capital per worker (k) So far, we have assumed that nothing would change with the decline in population growth rate. It is a commonly thought, however, that the change of population growth is closely related to the savings rate in society. 8

9 Savings rate saving rate (Source: The EIU Country Data, 2007) Savings rate Correlation between savings rate and population growth from Population growth rate (Source: The EIU Country Data, 2007) There are several explanations which relate the savings rate to the population growth rate. In the face of lower population growth and a growing burden of social expense, the government would increase the deficit, leading to a decline in public savings. As for the private sector, the increasing number of non-workers would lead to lower savings. People would also lose the incentive to save due to shrinking younger generation. Many changes suggest the reduced saving rate in the society. With the change in savings rate, capital per worker at the steady state would not increase as forecast in the first scenario. 9

10 investment depreciation (n 1 +δ)k (n 2 +δ)k investment depreciation (n 1 +δ)k (n 2 +δ)k s 1 f(k) s 1 f(k) s 2 f(k) s 2 f(k) k 2 k 1 capital per worker (k) k 1 k 2 capital per worker (k) In the second scenario, whether capital per worker actually grows or shrinks depends on the magnitude of changes in population growth rate and savings rate. In case capital per worker shrinks, income per worker, thus the standard of living, gets worse as well. In addition, since the lowering population growth rate shifts up the golden rule steady state level, lower savings rate makes the steady state much farer from the desired level of capital accumulation, which maximizes the consumption level in the society. investment depreciation k 1 GOLD k 2 GOL D (n 1 +δ)k f(k) investment depreciation k 1 GOLD k 2 GOL D (n 1 +δ)k f(k) (n 2 +δ)k (n 2 +δ)k s 1 f(k) s 1 f(k) s 2 f(k) s 2 f(k) k 2 k 1 capital per worker (k) k 1 k 2 capital per worker (k) 3) Quantitative analysis 1 So far, we have discussed the impact of lowering population growth rate on the change in the level of capital accumulation per worker and also the standard of living. As is evident, the magnitude and direction of the impact totally depends on the changes in population growth rate and savings rate 8. In this section, we quantitatively assess the relationship 8 We assume here the depreciation rate does not change over time. 10

11 between population growth and capital accumulation in the future Korean economy Population growth rate % Depreciation (δ) Savings rate (s) % K/worker at steady state (k * ) K/worker at Golden rule steady state (k * gold) The estimates suggest the impact of a decreasing savings rate would be larger than that of a lowering population growth rate. Declining capital per worker at the steady state leads to declining income per worker, thus lowering the standard of living in the future. In contrast to the decreasing steady state level of capital, which is strongly affected by a lowering savings rate, the golden rule steady state level of capital would increase due to lower population growth rate. The difference between the steady state and the golden rule steady state is expected to get larger; in this society, the consumption would be further below the optimal level. 4) Quantitative analysis 2 In the last two sections, we have assumed no technological change in the society, for simplicity s sake. Here, in order to check the sensitivity of the simulation, we change the assumption and estimate the changes again with the assumption of constant technological advancement in society. The results are below 10 ; 9 We adopt a set of assumptions as below: Production function: y = k 1/2 Depreciation rate in the future is the average between 1996 and As savings rate declines 4.2% within 10 years between 2000 and 2010, we assume the same drop rate for another 20 years. 10 We use the same assumptions as the previous two tables. Number of effective worker per worker is derived by 1 * (year-2005) 11

12 Population growth rate % Depreciation Savings rate % Technological progress % Number of effective worker per worker (2005=1) K/ effective worker at steady state (k * ) Y/ effective worker at steady state Y/ worker at the steady state K/ effective worker at Golden Rule steady state As in the former estimates, capital per effective worker at the steady state would decline while that at the golden rule steady state would increase. Therefore, the consumption level is forecast to go further from the optimal. On the other hand, as the number of effective workers would increase due to technological advancement, the income per worker is expected to slightly increase towards the future. IV. Policy Recommendations From the perspective of the long term growth rate at the steady state, we know that the larger population growth rate leads to a higher growth rate in GDP, and a smaller population growth rate leads to lower economic growth at steady state. In addition, low population growth may reduce the share of workers, which leads to an adverse effect on the growth rate of income per capita. Therefore, a higher population growth rate is better in this situation. From the viewpoint of the level of the standard of living, our simulation shows that it will decrease in the future reflecting the changes in population growth and savings rate. To avoid this situation, Korea should change the trend of key variables which affect the level of capital accumulation. As a set of policies to achieve this goal, we suggest the Korean government introduce policies with four goals: 1) increase fertility rate 2) adjust labor force structure 3) improve technology 4) increase savings rate. 1) For the long run, the South Korean government should adopt policies that encourage population growth. Since we find that a low fertility rate and an aging population may hurt economic growth in the long run, the Korean government should takes steps to increase the 12

13 fertility rate. We suggest the following policies to achieve this goal: 1) provide a directly subsidy to families who have children; 2) make laws friendly to mothers, such as allowing working mothers to have a reasonable paid maternity leave; 3) provide tax braks for families. In addition, indirect methods such as increasing day-care institutions and social care will also provide incentives to increase the fertility rate. Some developed countries also use immigration policy to increase the labor force and population. However, since Korea is a strongly nationalist society, which has historically excluded foreigners from participation in the labor force or in leadership positions, this trend will be difficult to reverse. Immigration levels have been relatively stagnant for many years, and will be likely remain so despite government efforts to the contrary. 2) Adjusting the labor force. Even if a country can not increase its population growth rate, it can still increase its GDP by increasing the number of workers. We have found that the percentage of women participating in the labor force in Korea is around 47%~50% 11, which still has space to increase. We suggest the government encourage women to work, by creating more incentives for companies to hire female workers and by providing female workers with training programs. Also, providing sufficient day care centers and ensuring that young Korean women receive a sound education equal to that of men can indirectly encourage homemakers to work as well. In addition to increase female workers, extending the retirement age could also be a beneficial to increase the number of overall workers. 3) Increasing the savings rate. In order to maintain enough investment that fuels growth, the Korean government should not let the savings rate continue to drop. One method is to change the tax structure by reducing the capital gains tax, corporate income tax 12, or estate tax. Secondly, we suggest the government replace the income tax with a consumption tax which can provide more incentives for saving. 4) Promoting technological progress. The impact of technological advancement on the changes in income per worker depends on variables such as savings rate and population growth as well as the technological growth rate itself. However, it is still the most critical factor in to achieving continuous growth at the steady state level. Therefore, we believe that higher growth in technology has an overall positive impact on the long-term Korean economy. There are several ways to promote technological progress, such as providing tax reduction for 11 National Statistical Office (NSO) of Korea, For a better tax structure in the future, we think reducing the capital gains tax and estate tax are better choices for Korea since certain industries have already received subsidy or tax reduction from the government. 13

14 business in research and development; providing grants for universities to do further research; strictly enforcing patent laws and property right protection regulations. If technological progress can keep Korea competitive on the international stage, we believe the negative impact of low fertility rate could be mitigated. It will be noticed that most of these policy recommendations such as reducing taxes and increasing R&D expenses could increase debts and the deficit, which could contradict our goal to increase public saving. However, according to the past record of the deficit and savings rate, we found that they were not directly correlative. In addition, compared to other developed countries, South Korea has a relatively low debt level. Therefore, we think it is better for the South Korean government to accumulate capital when its economy is healthy instead of using a constraint fiscal policy to reduce the deficit. Accumulating capital, investing and controlling consumption today may bring more benefits in the future. Coorelation between savings rate and public debt / GDP from savings rate (%) public debt / GDP (%) (Source: The EIU Country Data, 2007) 50 Total debt/gdp (%) (Source: The EIU Country Data, 2007) 14

15 Reference Korea Development Institute (KDI). March Population aging in Korea: economic impacts and policy issues. International Monetary Fund, World Economic Outlook Database. September National Statistical Office of Korea, Korean Statistical Information System. Retrieved on March 28, 2007 from UN The Sex and Age Distribution of World Population. US Department of State. Background Note: South Korea. Retrieved on April 4, 2007 from Economist Intelligent Unit, 2006 Country Profile 15

Economic Growth II. macroeconomics. fifth edition. N. Gregory Mankiw. PowerPoint Slides by Ron Cronovich Worth Publishers, all rights reserved

Economic Growth II. macroeconomics. fifth edition. N. Gregory Mankiw. PowerPoint Slides by Ron Cronovich Worth Publishers, all rights reserved CHAPTER EIGHT Economic Growth II macroeconomics fifth edition N. Gregory Mankiw PowerPoint Slides by Ron Cronovich 2002 Worth Publishers, all rights reserved Learning objectives Technological progress