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Economic Growth

Professor Chris AdamAustralian Graduate School of ManagementUniversity of Sydney and University of New

South Wales

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INTRODUCTION• Observe rising incomes and standards of living

• Know that level of GDP driven by– Capital

– Labour

– Technology

• Changes in GDP must come from changes in factors

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REAL GROWTH

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GROWTH OF COUNTRIES

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GROWTH MODEL

• Solow-Swan growth model (1956)

– “Dynamic capital accumulation”

– Can explain how growth occurs

– Can explain differences in growth

– Key elements are savings and population

growth

– Technological progress also important but not

covered here

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GROWTH MODEL

• Supply of goods and production

Y = F(K, L)

– Constant returns to scale

– Analyze all quantities relative to labour force:

Y/L = F(K/L, 1) or y = f(k)

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GROWTH MODEL

• Supply of goods and production

– Slope of function is marginal productivity of

capital per worker

– Slope declines with increased capital per

worker

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LABOUR PRODUCTIVITY

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GROWTH MODEL

• Demand for goods and consumption

– Output per worker divided between

consumption goods and investment goods

y = c + i

– Omits government and international sectors

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GROWTH MODEL

• Demand for goods and consumption

– Savings is fraction 0 < s < 1 of income, so

consumption is

c = (1 – s)y

– Implies investment equals saving: i = sy

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USING GROWTH MODEL

• Capital stock growth and steady state

– Investment (i) increases capital stock = savings

(sf(k)) increases capital stock

– Depreciation reduces capital stock: depreciation

rate =

– Change in capital stock k then

k = i – k

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USING GROWTH MODEL

• Capital stock growth and steady state

– Steady state when k = 0

– implying i = sf(k*) = k* for k* steady state

(constant) capital per worker

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USING GROWTH MODEL

• How savings affects growth

– Increased savings rate (s) means less

consumption per worker and more investment

– Leads to higher level of capital stock per

worker (k)

– Strong empirical support

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SAVINGS

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USING GROWTH MODEL

• What determines savings rates?

• Similar investment rates do not always

produce same income per worker – what

else matters?

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GOLDEN RULE OF GROWTH

• Is more savings always good?

– Gives larger capital stock per worker and higher

output per worker

– But reduces consumption per worker

• Want to compare steady states to see

which has highest consumption per worker

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GOLDEN RULE OF GROWTH

• Consider level of consumption at steady

state

c* = f(k*) – k*

Consumption is what is left of steady state output

after allowing for steady state depreciation

• Set level of savings to ensure c* is

maximized: this is Golden Rule Savings

– occurs when marginal product of k equals

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TRANSITION TO GOLDEN RULE

• Too much capital per worker:– Policy maker lowers saving rate to Golden Rule

level

– Increases consumption and reduces investment

– Investment rate now below depreciation rate

– Reduces output, investment further

– Consumption decreases from peak, but will remain above original level since at Golden Rule

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TRANSITION TO GOLDEN RULE

• Too little capital per worker:– Policy maker increases saving rate to Golden

Rule level

– Reduces consumption and increases investment

– Investment rate now above depreciation rate

– Increases output, investment further

– Consumption increases from dip, and will remain above original level since at Golden Rule

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POPULATION GROWTH

• Growth in population increases workforce– Dilutes capital and output per worker at steady

state

– Population growth rate (n) reduces capital stock per worker in same way as depreciation

k = i – (+ n)k

= sf(k) – (+ n)k

• Steady state k* from k = 0 = sf(k*) – (+ n)k*

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POPULATION GROWTH

• Growth in population has three effects on growth:– Better view of sustained growth drivers: total

output grows

– Better view of national income differences: higher population grow lowers GDP per person

– Golden Rule adjusted: now marginal product of capital per worker to equal ( + n)

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TAKEAWAYS

• Solow-Swan model shows– How saving sets steady state capital stock per

worker and steady state income per worker

– How population growth sets steady state capital stock per worker and steady state income per worker

– What policy makers might do to maximize consumption per worker in steady state