Long Run Growth

The World Economy

Total GDP (2013): $87T

Population (2013):7.1B
GDP per Capita (2013): $13,100
Population Growth (2013): 1.0%
GDP Growth (2013): 2.9%

GDP per capita is probably the best measure of a countrys overall well
being

Note. However, that growth rates vary significantly across countries/regions. Do

you see a pattern here?

Region

GDP

% of
World
GDP

GDP Per
Capita

Real GDP
Growth

United States

$17T

20%

$53,000

1.6%

European Union

$16T

18%

$35,000

0.1%

Japan

$4.7T

5%

$36,300

2.0%

China

$13T

15%

$9,800

7.7%

Ghana

$90B

.1%

$3,500

7.9%

Ethiopia

$118.2B

.13%

$1,300

7.0%

Source: CIA World Factbook (2013 Estimates)

Per Capita Income

At the current trends, the standard of living in China will surpass that of the US in
25 years! Or, will they?

That is, can China maintain its current growth rate?

As a general rule, low income (developing) countries tend to have

higher average rates of growth than do high income countries

Income

GDP/Capita

GDP Growth

Low

< $1,045

6.3%

Middle

$1,045 - $12,746

4.8%

High

>$12,746

3.2%

The implication here is that eventually, poorer countries should

eventually catch up to wealthier countries in terms of per capita income
a concept known as convergence

Source: World Bank (2013 estimates)

Some countries, however, dont fit the normal pattern of development

Sudan
GDP: $107B (#73)
GDP Per Capita: $5,100 (#159)
GDP Growth: -2.3% (#213)

Macau
GDP: $51.6B (#98)
GDP Per Capita: $88,700 (#3)
GDP Growth: 11.9% (#5)

At current trends, Per capita income in Macau will triple to $273,000

over the next decade. Over the same time period, per capita GDP
in Sudan will drop by roughly 25%to $4,000!!!
So, what is Sudan doing wrong? (Or, what is Macau doing right?)

To understand this, lets look at the sources of economic growth.where

does production come from?
is a function of

Real GDP

Y F A, K , L
Productivity Capital
Stock

Labor

Real GDP = Constant Dollar (Inflation adjusted) value of all goods and
services produced in the United States
Capital Stock = Constant dollar value of private, non-residential fixed assets
Labor = Private Sector Employment
Productivity = Production unaccounted for by capital or labor

A convenient functional form for growth accounting is the Cobb-Douglas

production function. It takes the form:

Y AK L

where

With the Cobb-Douglas production function, the parameters have clear

interpretations:

Capitals share of income (what %

of total income in the US accrues to
owners of capital)

Labors share of income (what % of

total income in the US accrues to
owners of labor)

Elasticity of output with respect to

capital (% increase in output
resulting from a 1% increase in
capital)

Elasticity of output with respect to

labor (% increase in output resulting
from a 1% increase in labor)

Suppose we have the following Cobb-Douglas production function:

A 1% rise in capital
raises GDP by 1/3%

A 1% rise in
employment raises
GDP by 2/3%

1
3

2
3

Y AK L

We can rewrite the production function in terms of growth rates to decompose

GDP growth into growth of factors:

1
2
%Y %A %K %L
3
3

Real GDP Growth

(observable)

Productivity Growth
(unobservable)

Capital Growth
(observable)

Employment
Growth
(observable)

Year

Real GDP (Billions of

2009 dollars)

Real Capital Stock

(Billions of 2005 dollars)

Employment (thousands)

2010

14,939

40,615

130,745

2011

15,190

40,926

132,828

Lets decompose some recent data first

%Y ln 15,190 ln 14,939 *100 1.67

%K ln 40,926 ln 40, 615 *100 .76
%L ln 132,828 ln 130, 745 *100 1.58

%A 1.67

1
2
.76 1.58 .36
3
3

*Source: Penn World Tables

Year

Real GDP (Billions of

2009 dollars)

Real Capital Stock

(Billions of 2005 dollars)

Employment (thousands)

1950

2,273

6,328

46,855

2011

15,190

40,926

132,828

Now, lets look at long term averages

%Y

ln 15,190 ln 2, 273

%K

ln 40, 926 ln 6, 328

%L

ln 132,828 ln 46,855

61
61

61

*100 3.11
*100 3.06

*100 1.70

%A 3.11

1
2
3.06 1.70 .98
3
3

Contributions to growth from capital, labor, and technology vary across time
period
1939 1948

1948 1973

19731990

19902007

20072013

Output

5.79

4.00

3.10

3.60

1.1

Capital

3.34

3.70

4.20

4.10

1.4

Labor

4.46

1.00

1.90

1.60

-0.1

Productivity

1.71

2.1

0.5

1.2

0.7

A few things to notice:

Real GDP growth is declining over time.

Capital has been growing faster than labor
The contribution of productivity is diminishing!

Annual Growth

Generally speaking, productivity growth has been declining since WWII

Our model of economic growth begins with a production function

1
3

Real GDP

2
3

Y AK L

Productivity Capital
Stock

Labor

Given our production function, economic growth can result

from
Growth in labor
Growth in the capital stock
Growth in productivity

We are concerned with capital based growth. Therefore, growth in productivity

and employment will be taken as given
1
3

2
3

Y AK L

gL

Productivity
grows at rate

L
L

LF

gA

Employment
Labor Force

Population
grows at rate

= Employment Ratio

( Assumed Constant)

LF

Pop
Pop

Labor Force
Population

= Participation rate

( Assumed Constant)

1
3

Our simple model of economic growth

begins with a production function with
one key property diminishing marginal
product of capital
Change in Production

Y AK L

F ( A, K , L )
Y

Y
MPK
K

Change in Capital Stock

As the capital stock

increases (given a fixed
level of employment), the
productivity of capital
declines!!

2
3

Y
K

An economy cant grow through capital accumulation alone forever!

Everything in this model is in per capita terms

1
3

2
3

Y AK L

Divide both sides by labor to represent our variables in per capita terms
1
3

2
3

Y
AK L
K
y
A

1 2
L
L
3 3
L L
Per capita
output

1
3

Ak

1
3

Capital Per Capita

Productivity

In general, lets assume lower case letters refer to per capita variables

Again, the key property of production is that capital exhibits diminishing marginal
productivity that is as capital rises relative to labor , its contribution to production
of per capita output shrinks

Output per capita

y Ak

1
3

Capital stock per

capita

Lets use an example. The current level of capital per capita will determine
the current standard of living (output per capita = income per capita)

y Ak

1
3

gA 0

1
3

y 6 8 12

g L 2%
A6
K 8,000
L 1,000

k
k 8

Next, assume that households save a constant fraction of their disposable

income
Income Less Taxes

S Y T
Savings

Constant between zero and one

Again, convert everything to per capital terms by dividing through by the

labor force

S
Y T

L
L L

s y t

KEY POINT:
Savings = Household income that hasnt been spent
Investment = Corporate purchases of capital goods (plant, equipment, etc)
The role of the financial sector is to make funds saved by households
available for firms to borrow for investment activities

Households save
their income by
opening savings
accounts, buying
stocks and bonds,
etc

Firms access these

funds by taking out
loans, issuing stocks
and bonds, etc. and
use the funds for
investment activities

s y t
S=I

I
i
L
Investment
per capita

Continuing with our example:

y, s

10%
t 0

y Ak

1
3

y 6 8 3 12

i s y t

i .10 12 0 1.2

k 8

Investment represents the purchase of new capital equipment. This

will affect the capital stock in the future

Annual Depreciation
Rate

K ' (1 ) K I
Future capital stock

Investment
Expenditures

current capital stock

We need to write this out in per capita terms as

well

We need to write this out in per capita terms as well

K'
K I
(1 )
L
L L

K ' L'
K I
(1 )
L' L
L L

Divide through by labor to get things in per capita

terms

Multiply and divide the left hand side by future

labor supply

Recall that labor grows at a constant rate

K ' L'
K I

(1 )

L' L
L

L
L'
(1 g L )
L

k 1 g L (1 )k i
'

(1 )k i
k
1 gL
'

The evolution of capital per capita

Annual depreciation rate

Current capital per

capita

(1 )k i
k'
1 gl
Future capital stock per
capita

Investment per
capita

Annual population
growth rate

In our example
10%
g L 2%
k 8
i s 1.2

Given
Calculated

(1 .10)8 1.2
k'
8.24
1 .02

Just as a reference, lets figure out how much investment per capita would be
required to maintain a constant level of capital per capita

~
k 1 g L (1 )k i
'

k k
'

Evolution of per capita capital

Assume constant capital per capita

~
i g L k

Solve for investment

In our example
10%
g L 2%
Given
L 1,000
K 8,000
I S 1,200 Calculated

~
i .10 .02 8 .96

Just to make sure, lets check our numbers

In our example
10%
g L 2%
L 1,000
K 8,000

~
i .10 .02 8 .96

The evolution of capital per capita

(1 )k i
k'
1 gl

(1 .10)8 .96
k'
8k
1 .02

Lets update our diagram

break even investment

~
i gL k

~
y , i, i

y Ak

1
3

i s y t
1

y 6 8 3 12
Actual investment

i s 1. 2

~
i .96

k 8

Now we have all the components to calculate next years output per capita and the
rate of growth

(1 .10)8 1.2
k'
8.24
1 .02
gA 0
g L 2%
A6
k 8
i 1.2
k ' 8.24

Output per
capita growth

Given

Calculated

y ' A' k '

1
3
1
3

y ' 6 8.24 12.11

g y ln 12.11 ln 12 *100 .91%

Lets update our diagram

~
i gL k

~
y , i, i

y Ak

1
3

i s y t

y 12.11
y 12
i s 1. 2

~
i .96

k 8

k ' 8.24

Lets repeat that process again

10%
T t 0

gA 0
g L 2%
A6
K 8,405
L 1,020

Capital

k ' 8.24

Savings = Investment

Output
1
3

y 6 8.24 12.11

Evolution of Capital

(1 )k i 1 .10 8.24 1.211

k'

8.46
1 gL
1.02

s .1012.11 0 1.211

New Output
1
3

y ' 6 8.46 12.22

Output Growth

g y ln 12.22 ln 12.11 *100 .90%

Growth is slowing downwhy?

The rate of growth depends on the level of investment relative to the break even
level of investment.
Actual investment
based on current
savings

~
y , i, i

~
i gL k

y Ak

1
3

i s y t

is
~
i

Level of investment
needed to maintain
current capital stock

Eventually, actual investment will equal break even investment and growth ceases
(in per capita terms). This is what we call the steady state.
~
i gL k

~
y , i, i

y Ak

y ss

1
3

i s y t

~
isi

k ss

The steady state has three conditions.

y Ak

1
3

s y t

Savings per capita is a

constant fraction of
output per capita

Output is a function
of capital per capita

i g L k

Investment is sufficient to
maintain a constant
capital/labor ratio

Recall that, in
equilibrium, savings
equals investment

si

With a little algebra, we can solve for the steady state in our example.

i g L k

gA 0
g L 2%
A6
t 0

10%
10%

Start with condition 3

y t g L k

Ak t g L k

1
3

1
3

Ak g L k

k
gL

3
2

Use condition 2 and the fact that

savings equals investment

Substitute condition 1

Recall that taxes are zero in our

example

Solve for k

Plugging in our parameters gives us steady state values.

gA 0
g L 2%
A6
t 0

10%
10%

k
gL
1
3

3
2

.10 * 6

.
10

.
02

3
2

11.18

1
3

y Ak 611.18 13.40

Steady state per

capita capital

Steady state per

capita output

s y t .1013.40 0 1.34

Steady state per capita

savings/investment

c 1 y t .913.40 0 12.06
k'

(1 )k i 1 .10 11.18 1.34

11.18
1 gL
1 .02

Steady state per capita

consumption

Constant per capita

capital!!!

Eventually, actual investment will equal break even investment and growth ceases
(in per capita terms). This is what we call the steady state.
~
i gL k

~
y , i, i

y Ak

y ss 13.40

1
3

i s y t

i s 1.34

In the steady state (with no

productivity growth), all per capita
variables have zero growth!

k ss 11.18

Suppose we started out example economy above its eventual steady

state
1
3

g L 2%
A6
K 15,000
L 1,000
t 0

10%
10%

1
3

y Ak 615 14.8

gA 0

k 15

i s y t .1014.8 0 1.48
k'

(1 )k i 1 .10 15 1.48

14.7
1 gL
1 .02
1
3

1
3

y ' Ak ' 614.7 14.7

% y ln 14.7 ln 14.8 *100 .68%
An economy above its steady state shrinks (in per capita terms) towards its steady state.

An economy above its steady state shrinks (in per capita terms) towards its steady state.

~
y , i, i

~
i gL k

y Ak

1
3

y 14.8
~
i 1 .8

i s y t

i 1.48

An economy above its steady

state cant generate enough
savings to support its capital
stock!
k 15

Absolute convergence refers to the premise that

every country will converge towards a common steady
state

Investment needed
to maintain current
capital/labor ratio
Actual investment
(equals savings)

Actual investment
(equals savings)
Investment needed
to maintain current
capital/labor ratio

Countries below their

eventual steady state will
grown towards it

Steady
State

k
Countries above their
eventual steady state will
shrink towards it

Countries at their eventual

steady state will stay there

Most countries follow the usual pattern of development

Developing countries have very little capital, but A LOT of labor. Hence,
the price of labor is low, the return to capital is very high

High returns to capital attract a lot of investment. As the capital stock

grows relative to the labor force, output, consumption, and real wages
grow while interest rates (returns to capital fall)

Eventually, a country matures (i.e. reaches its steady state level of

capital). At this point, growth can no longer be achieved by investment
in capital. Growth must be knowledge based improving productivity!

Productivity

y Ak

1
3

Does the economy

have a speed
limit?
Economic Growth can be broken into three components:
GDP
= Productivity Growth + (2/3)Labor Growth + (1/3)Capital Growth
Growth
In the Steady State, Capital Growth = Labor Growth

GDP
Growth

= Productivity Growth + Labor Growth

( GDP Per Capita Growth = Productivity Growth)

Developing countries are well below their steady state and, hence should grow
faster than developed countries who are at or near their steady states a
concept known as absolute convergence
Examples of Absolute Convergence (Developing Countries)
China (GDP per capita = $6,300, GDP Growth = 9.3%)
Armenia (GDP per capita = $5,300, GDP Growth = 13.9%)
Chad (GDP per capita = $1,800, GDP Growth = 18.0%)
Angola (GDP per capita = $3,200, GDP Growth = 19.1%)
Examples of Absolute Convergence (Mature Countries)
Canada (GDP per capita = $32,900, GDP Growth = 2.9%)
United Kingdom (GDP per capita = $30,900, GDP Growth = 1.7%)
Japan (GDP per capita = $30,700, GDP Growth = 2.4%)
Australia (GDP per capita = $32,000, GDP Growth = 2.6%)

Some countries, however, dont fit the traditional pattern.

Developing Countries with Low Growth

Madagascar(GDP per capita = $900, GDP Growth = - 2.0%)
Iraq (GDP per capita = $3,400, GDP Growth = - 3.0%)
North Korea (GDP per capita = $1,800, GDP Growth = 1.0%)
Haiti (GDP per capita = $1,200, GDP Growth = -5.1%)
Developed Countries with high Growth
Hong Kong (GDP per capita = $37,400, GDP Growth = 6.9%)
Iceland (GDP per capita = $34,900, GDP Growth = 6.5%)
Singapore (GDP per capita = $29,900, GDP Growth = 5.7%)
Qatar (GDP Per Capita = $179,000, GDP Growth = 16.3%)

Consider two countries

We already
calculated
this!

Country A

Country B

gA 0

gA 0

g L 2%

g L 15%

A6
t 0
10%

A6
t 0
10%

10%
K 8,000
L 1,000

10%
K 4,000
L 1,000

1
3

1
3

y Ak 6 4 9.52

i s y t .10 9.52 0 .952

k'

(1 )k i 1 .10 4 .952

3.95
1 gL
1 .15
1
3

1
3

y ' Ak ' 6 3.95 9.48

g y ln 9.48 ln 9.52 *100 .41

y 12
g y .91%
Even though Country B is poorer, it is growing
slower than country A (in per capita terms)!

With a higher rate of population growth, country B has a much lower steady state than country A!!!

~
y , i, i

~
iB .15 .10 k

~
iA .02 .10 k

s y t i

g L

k B ss

3
2

k 4
B

.10*6 2
3.71
.10 .15

k 8
A

ss

11.18

Conditional convergence suggests that every country converges to its own unique
steady state. Countries that are close to their unique steady state will grow slowly
while those far away will grow rapidly.
Haiti
Population Growth: 2.3%

High Population Growth

(Haiti)

Low Population Growth

(Argentina)

GDP/Capita: $1,600
GDP Growth: -1.5%

Argentina
Population Growth: .96%
GDP/Capita: $13,700
GDP Growth: 8.7%

Steady
State

Steady State
(Argentina)

(Haiti)

Haiti is currently ABOVE its

steady state (GDP per capita
is falling due to a high
population growth rate

Argentina, with its low

population growth is well
below its steady state
growing rapidly towards it

Conditional convergence suggests that every country converges to its own unique
steady state. Countries that are close to their unique steady state will grow slowly
while those far away will grow rapidly.
Zimbabwe (until recently)
GDP/Capita: $2,100

GDP Growth: -7%

High Savings Rate

(Hong Kong)

Investment Rate (%0f GDP): 7%

Hong Kong
Low Savings Rate
(Zimbabwe)

GDP/Capita: $37,400
GDP Growth: 6.9%
Investment Rate (% of GDP): 21.2%

Steady State

Steady State

(Zimbabwe)

(Hong Kong)

Zimbabwe is currently
ABOVE its steady state (GDP
per capita is falling due to
low investment rate

Hong Kong, with its high

investment rate is well below
its steady state growing
rapidly towards it

Conditional convergence suggests that every country converges to its own unique
steady state. Countries that are close to their unique steady state will grow slowly
while those far away will grow rapidly.
France
GDP/Capita: $30,000

GDP Growth: 1.6%

Small Government (US)

Government (%0f GDP): 55%

Large Government
(France)

USA
GDP/Capita: $48,000
GDP Growth: 2.5%
Government (% of GDP): 18%

Steady State Steady State

(France)

France has a lower steady state due

to its larger public sector. Even
though its per capita income is lower
than the US, its growth is slower

(USA)

The smaller government of

the US increases the steady
state and, hence, economic
growth

Suggestions for growth.

High income countries with low growth are at or near their steady state.
Policies that increase capital investment will not be useful due to the
diminishing marginal product of capital.

Consider investments in technology and human capital to increase

your steady state.

Consider limiting the size of your government to shift resources to

more productive uses (efficiency vs. equity)

Low income countries with low growth either have a low steady state or are
having trouble reaching their steady state

Consider policies to lower your population growth.

Try to increase your pool of savings (open up to international capital
markets)

Policies aimed at capital formation (property rights, tax credits, etc).

Question: Is maximizing growth a policy we should be striving for?

y Ak

1
3

y ci

Our model begins with a relationship

between the capital stock and production

These goods and services that we produce

can either be consumed or used for
investment purposes (note: taxes are zero)

y c g L k

1
3

In the steady state, investment simply

maintains the existing steady state

c y g L k Ak g L k

Maybe we should be choosing a steady

state with the highest level of
consumption!

Steady state consumption is a function of steady state capital. If we want to maximize steady
state consumption, we need to look at how consumption changes when the capital stock changes
1
3

c Ak g L k

dc 1
Ak 3 g L
dk 3

Change in
consumption
per unit change
in steady state
capital

Change in
production per
unit change in
steady state
capital

Change in
capital
maintenance
costs per unit
change in
steady state
capital

dc 1
Ak 3 g L 0
dk 3

~
y, i

~
i gL k

y Ak

1
3

Consumption equals zero capital

maintenance requires all of
production

Steady state
consumption is
maximized!!!

k*
In this region, an increase in capital
increases production by more than
the increase in maintenance costs
consumption increases

In this region, an increase in capital

increases production by less than
the increase in maintenance costs
consumption decreases

Lets go back to our example

1
Ak 3 g L 0
3

3 g L

k *

3
2

We can solve for the steady state

capital that maximizes consumption

gA 0
g L 2%
A6
t 0
10%
10%

3 .10 .02

k *

3
2

68

~
y , i, i

~
i gL k

y Ak

1
3

i s .10 y t

k * 11
Steady state with a
10% investment rate

k * 68
Steady state capital
that maximizes
consumption

k max 353

Maximum sustainable
capital stock
consumption equals
zero

Using our example, lets compare consumption levels

gA 0

Steady State with Savings Rate = 10%

g L 2%
A6
t 0

10%
10%

.10 * 6
k

.
10

.
02

3
2

11.18

1
3

Optimal Steady State

3 .10 .02

k *

3
2

68

y 611.18 13.40

y 6 68 24.5

i .02 .10 11.18 1.34

i .02 .10 68 8.16

c 13.40 1.34 12.06

1
3

c 24.5 8.16 16.34

In this example, we could increase

consumption by 30% by altering
the savings rate!!

By comparing steady states, we can find the savings rate associated with
maximum consumption
gA 0

Steady State with a given Savings Rate

g L 2%
A6
t 0

10%
10%

k
gL

Optimal Steady State

k*

13 A

3
2

g
L

3
2

1
3

To maximize steady state

consumption, we need a 33%
savings/investment rate!!