Chapter 12: Growth Theory Macro Econ

The aggregate production function in equation form as

GDP=Y=F(physical capital, human capital, natural resources) - Where Y is real output, or GDP - K: physical capital - HK: human capital - L: natural resources

What is the Solow Growth Model?

Growth theory started almost 60 years ago with Robert Solow The Solow model still forms the basis of growth theory, but the theory has changed significantly over the past two decades

Modern growth theory

Highlights institutions that foster endogenous growth

Two types of aid in the 1950s and 1960s

- Actual capital goods were built with aid - Aid given to developing countries to fund infrastructure

Diminishing Marginal Product on a graph

- Line flattens out on a graph - The shape of the production function, in which the slope is declining, illustrates the diminishing marginal product of capital

Technology and the Production Function

- New technology increases the slope of the production function as the marginal product of capital increases. - After the Technological innovation (represented by A), capital is more productive, and this outcome leads to new economic growth. - If technology continues to advance, economic growth can be sustained.

Aggregate production function graph

- On the vertical axis, we have output for the macroeconomy, which is real GDP (Y) - Assume no population growth, then economic growth is represented as movements upward along the vertical axis - On the horizontal axis, capital resources (K) increase from left to right - Slope of the function is positive, which indicates positive marginal product - But the marginal product declines as more capital is added

Increases in technology

- Produce more output with each input unit - A zero-growth long-run equilibrium is avoidable - Graphically, as MPK increases, the production function shifts upward

Aggregate production function

- The aggregate production function describes the relationship between all the inputs used in the macroeconomy and economy's total output, where GDP is output. - The aggregate production function tells us that GDP is a function of three broad types of resources, or factors of production, which are inputs used in producing goods and services. - These inputs are physical capital, human capital, and natural resources.

Results of Solow

- Wealth comes from capital and Technology - Wealthy nations fund capital investment in poor countries

Principle of Diminishing Marginal Product

- Which states that the marginal product of an input falls as the quantity of the input rises. - Diminishing marginal product generally applies across all factors of production at both the microeconomics and the macroeconomics levels.

Exogenous Technical Change

- that exogenous factors are the variables that cannot be controlled for in a model - the implication is that technological innovations just happen—they are not based on economics. In this sense, technological innovations occur randomly. - If some nations get more technological innovations than others, then that is just their good fortune.

Convergence

- the idea that per capita GDP levels across nations will equalize as nations approach the steady state - The Solow model implies that the United States is closer to its steady state and therefore grows more slowly than China.

Results of policies

-Some countries received billions in aid and are no better off today than they were in 1960 -Some countries received almost no aid and have grown rapidly

Institutions That Foster Economic Growth

1. Political Stability and rule of law 2. Private property rights 3. Competitive markets 4. International trade 5. The flow of funds across borders 6. Efficient taxes 7. Stable money and prices

MP - capital

Change in output from one-unit in capital

Production and Investment occur naturally under certain conditions

Example: - Decision whether or not to attend college - Believe that your degree will result in higher wages above the cost of tuition and the opportunity cost of 4 years' income Voluntary investment in human capital

Voluntary investment occurs if:

Expected payoff ≥ Costs - Spent resources and work are required before output is produced -Time lag before payoffs

The Evolution of Growth Theory

In 1776, Adam Smith published his renowned book An Inquiry into the Nature and Causes of the Wealth of Nations. This book was the real economics textbook, and, as the title indicates, it focused on what makes a nation wealthy. After the Great depression in 1930s, Macroeconomics focused on the study of the business cycle, or short run expansions and contractions.

production function

In microeconomics theory, a firm's production function describes the relationship between the inputs a firm uses and the output it creates. For the macroeconomy, output is GDP

Institutions

Institutions are significant practices, relationships, or organizations in society that frame the incentive structure within which individuals and business firms act. Institutions are the rules of the game, both formal and informal, framing the environment within which production takes place. They help determine the cost and benefits of production

Why are the proper institutions important for creating economic growth?

Institutions create the incentive structure in which growth can occur.

Net investment

Investment Minus depreciation - To increase capital stock, net investment > 0 - In a steady state, there is no net investment

The Interplay between the Real World and Economic Theory

Observations of the real world shape economic theory. Economic theory then informs policy decisions that are designed to meet certain economic goals. Once these policies are implemented,they affect the real world. Further real world observation contribute to additional advances in economic theory and the cycle continues

How does modern growth theory model technology and technological change?

Technology change is endogenous and depends on factors that currently exist in the economy.

In the second Solow model, how were technology advances modeled?

Technology shocks were considered random and exogenous.

Depreciation

The Fall in value of a resource overtime - Factories become outdated - Machines wear down - Roads crumble

The first version of the Solow model focused on what? Why?

The first version of the Solow model focused on Capital resources Reasoning: - Increasing tools available can increase output per worker - Capital in wealthy nations exceeds capital in developing nations - Periods of investment growth are periods of expansion

Expected payoff

The payoffs come later than the costs and are uncertain, which is why we call them

Negative vs. Positive institutions

The right institutions lead to economic growth - Positive institutions: transparent and consistent government, private property rights, stable money and prices - Negative institutions: corruption, political instability

Solow II equation

Y = A x F( physical capital, human capital, natural resources) - where "A" represents technology

If we include institutions in the aggregate production function, we have:

Y=A×F(physical capital,human capital,natural resources,institution) - With these institutions in place, there are incentives for new technology to emerge and drive growth. - Institutions can affect the production function, causing it to rise from F_1 to F_2

MP > 0 however?

a resources MP declines as the quantity of the resources increases

Time lag

depends on the type of output, but the payoffs from all output come sometime after the expenditures on resources

Endogenous Growth

growth driven by factors inside the economy

Exogenous growth

growth that is independent of any factors in the economy

According to the idea of diminishing marginal product, where will capital have the highest marginal productivity?

in countries with a small amount of capital

What is an indicator of economic growth?

life expectancy

Institutions are the key ingredient to what?

long-run growth

MPK

marginal product of capital

In equation form, the production function for a single firm is

q = f (physical capital, human capital) Where q is the firm's output. Equation says that output is a function of quantities of physical capital and human capital that the firm uses.

Technology

refers to the knowledge that is available for use in production.

Factors that contribute to economic growth

resources, technology, institution

Marginal product

the change in output associated with one additional unit of input MP- physical capital 0 MP- human capital 0 MP- natural resources 0 More resources (inputs) increase output, so we say the marginal product of each resource is positive.

Steady states

the condition of a macroeconomy when there is no new net investment There is no incentive to invest if the cost of investment is greater than the return on investment. When the economy reaches its steady state, real GDP is no longer increasing and economic growth stops.

Two Theoretical Implications of the Solow Model

the conditions of a steady state and convergence.

The steady state is a direct implication of diminishing return:

when the marginal return to capital declines, at some point there is no incentive to build more capital.