growth theory: review - university of southampton
TRANSCRIPT
Growth AccountingThe Solow Model
Savings behaviourThe One Sector Growth Model
Growth Theory: ReviewLecture 1.1, Exogenous Growth
Topics in Growth, Part 2
June 11, 2007
Lecture 1.1, Exogenous Growth 1/76 Topics in Growth, Part 2
Growth AccountingThe Solow Model
Savings behaviourThe One Sector Growth Model
Growth Accounting: Objective and Technical FrameworkTFP residualDecomposing growth in GDP per workerResults
Growth Accounting: Objective 2
◮ Many factors play role to determine output in a country
◮ Certainly, size of the labour force and capital stock do◮ But also, education, government regulation, weather,...
◮ Any theory of economic growth chooses which of thesefactors to emphasize as
◮ sources of GDP growth within countries◮ explanation for differences in levels/growth rates across
countries
◮ Growth accounting:tool to evaluate relative importance of such factors →Theory & Policy Implications
Lecture 1.1, Exogenous Growth 2/76 Topics in Growth, Part 2
Growth AccountingThe Solow Model
Savings behaviourThe One Sector Growth Model
Growth Accounting: Objective and Technical FrameworkTFP residualDecomposing growth in GDP per workerResults
Technical framework 3
◮ Ignore the demand side for now
◮ Carefully specify the supply side
◮ Inputs: capital, K , and labour, L
◮ Output, Y
◮ State of technology, A
Lecture 1.1, Exogenous Growth 3/76 Topics in Growth, Part 2
Growth AccountingThe Solow Model
Savings behaviourThe One Sector Growth Model
Growth Accounting: Objective and Technical FrameworkTFP residualDecomposing growth in GDP per workerResults
Technology, F 4
Y = F (K , AL) where
Y = output
K = capital (input / factor)
L = labour (input / factor)
A = state of technology
H = AL = effective labour
Assumptions◮ Marginal products positive and diminishing◮ Constant returns to scale
Lecture 1.1, Exogenous Growth 4/76 Topics in Growth, Part 2
Growth AccountingThe Solow Model
Savings behaviourThe One Sector Growth Model
Growth Accounting: Objective and Technical FrameworkTFP residualDecomposing growth in GDP per workerResults
Marginal products 5
◮ Marginal product of labour
◮∂F∂L = FL > 0 positive
◮∂
2F∂L2 = FLL < 0 and diminishing
◮ Marginal product of capital
◮∂F∂K = FK > 0 positive
◮∂
2F∂K 2 = FKK < 0 and diminishing
Lecture 1.1, Exogenous Growth 5/76 Topics in Growth, Part 2
Growth AccountingThe Solow Model
Savings behaviourThe One Sector Growth Model
Growth Accounting: Objective and Technical FrameworkTFP residualDecomposing growth in GDP per workerResults
Constant returns to scale (CRS) 6
F (λK , AλL) = λF (K , AL) for λ > 0
◮ Implications of CRS
◮ Size (of firms) does not matter → representative firm
◮ Euler’s theorem: Factor payments exhaust the output
◮ See example
Lecture 1.1, Exogenous Growth 6/76 Topics in Growth, Part 2
Growth AccountingThe Solow Model
Savings behaviourThe One Sector Growth Model
Growth Accounting: Objective and Technical FrameworkTFP residualDecomposing growth in GDP per workerResults
Cobb-Douglas production function 7
F (K , AL) = K α(AL)1−α 1 > α > 0
◮ CRS◮ Positive and diminishing MP
Lecture 1.1, Exogenous Growth 7/76 Topics in Growth, Part 2
Growth AccountingThe Solow Model
Savings behaviourThe One Sector Growth Model
Growth Accounting: Objective and Technical FrameworkTFP residualDecomposing growth in GDP per workerResults
Steps for growth accounting 8
◮ TFP residual, At , for K only production function
◮ TFP residual, At , across countries: K only
◮ TFP residual, At , including human capital
◮ TFP residual, At , across countries: K and H
◮ Decomposing growth in GDP per worker: K only
◮ Decomposing growth in GDP per worker: K and H
◮ Summary of results
◮ Critique
Lecture 1.1, Exogenous Growth 8/76 Topics in Growth, Part 2
Growth AccountingThe Solow Model
Savings behaviourThe One Sector Growth Model
Growth Accounting: Objective and Technical FrameworkTFP residualDecomposing growth in GDP per workerResults
TFP, At , as residual for K only production function 9
◮ From the production function in year t
Yt = AtK αt L1−α
t
◮ Denoting “per worker” variables in lower case letters,i.e., output per w. yt = Yt
Ltand capital per w. kt = Kt
Lt
◮ After dividing by Lt , we rewrote production functionYtLt
= At(KtLt
)α(LtLt
)1−α as yt = Atkαt
◮ Hence, by rearranging we got
At = ytkα
t
Lecture 1.1, Exogenous Growth 9/76 Topics in Growth, Part 2
Growth AccountingThe Solow Model
Savings behaviourThe One Sector Growth Model
Growth Accounting: Objective and Technical FrameworkTFP residualDecomposing growth in GDP per workerResults
CRS production function with physical and humancapital 10
◮ Now include human capital (e.g., years of education) intoproduction function (Make sure production function is CRSand positive and diminishing MP)
◮ We will use Yt = AtF (Kt , Ht , Lt) = AtK αt Hβ
t L1−α−βt ,
with α, β ∈ [0, 1] (parameters)
◮ Note: AtF (λKt , λHt , λLt) = λAtF (Kt , Ht , Lt) → CRS
Lecture 1.1, Exogenous Growth 10/76 Topics in Growth, Part 2
Growth AccountingThe Solow Model
Savings behaviourThe One Sector Growth Model
Growth Accounting: Objective and Technical FrameworkTFP residualDecomposing growth in GDP per workerResults
TFP as residual for production function with K and H11
◮ From the production function in year t
Yt = AtK αt Hβ
t L1−α−βt
◮ Denoting “per worker” variables in lower case letters,i.e., output per w. yt = Yt
Lt, phys. capital per w. kt = Kt
Ltand
human capital per w. ht = htLt
◮ After dividing by Lt , we can rewrite the production functionYtLt
= At(KtLt
)α(HtLt
)β(LtLt
)1−α−β as yt = Atkαt hβ
t◮ Hence, by rearranging we get
At = yt
kαt hβ
t
Lecture 1.1, Exogenous Growth 11/76 Topics in Growth, Part 2
Growth AccountingThe Solow Model
Savings behaviourThe One Sector Growth Model
Growth Accounting: Objective and Technical FrameworkTFP residualDecomposing growth in GDP per workerResults
Compare At for the 2 production functions 12
◮ Residual for production function with physical capital onlyAt = yt
kαt
◮ Residual for production function with human capitalAt = yt
kαt hβ
t
◮ Difficult to measure β
Lecture 1.1, Exogenous Growth 12/76 Topics in Growth, Part 2
Growth AccountingThe Solow Model
Savings behaviourThe One Sector Growth Model
Growth Accounting: Objective and Technical FrameworkTFP residualDecomposing growth in GDP per workerResults
Decomposing GDP per worker growth: K only 13
◮ Now that we have a series for At , we want to decomposegrowth in GDP per worker into growth in the capital stockversus growth in productivity.
◮ Last time, we derived
log yt+1 − log yt = log At+1 − log At + α(
log kt+1 − log kt
)
log yt+1−log ytlog yt+1−log yt
=log At+1−log Atlog yt+1−log yt
+ αlog kt+1−log ktlog yt+1−log yt
1 = 100% =log At+1−log Atlog yt+1−log yt
+ αlog kt+1−log ktlog yt+1−log yt
Lecture 1.1, Exogenous Growth 13/76 Topics in Growth, Part 2
Growth AccountingThe Solow Model
Savings behaviourThe One Sector Growth Model
Growth Accounting: Objective and Technical FrameworkTFP residualDecomposing growth in GDP per workerResults
Decomposing GDP per worker growth: K and H 14
◮ Now that we have a series for At , we want to decomposegrowth in GDP per worker into growth in the capital stockversus growth in human capital versus growth inproductivity (TFP).
◮ Growth in output per worker is
yt+1yt
=At+1(kt+1)α(ht+1)β
At(kt )α(ht+1)β
yt+1yt
=At+1At
(kt+1kt
)α(ht+1ht
)β
◮ Next, as before we go to logs so we have a sum.
Lecture 1.1, Exogenous Growth 14/76 Topics in Growth, Part 2
Growth AccountingThe Solow Model
Savings behaviourThe One Sector Growth Model
Growth Accounting: Objective and Technical FrameworkTFP residualDecomposing growth in GDP per workerResults
Decomposing GDP per worker growth: K and H 15
log yt+1 − log yt =
log At+1 − log At + α(
log kt+1 − log kt
)
+ β(
log ht+1 − log ht
)
log yt+1−log ytlog yt+1−log yt
=log At+1−log Atlog yt+1−log yt
+ αlog kt+1−log ktlog yt+1−log yt
+ βlog ht+1−log htlog yt+1−log yt
1 = 100% =log At+1−log Atlog yt+1−log yt
+ αlog kt+1−log ktlog yt+1−log yt
+ βlog ht+1−log htlog yt+1−log yt
Lecture 1.1, Exogenous Growth 15/76 Topics in Growth, Part 2
Growth AccountingThe Solow Model
Savings behaviourThe One Sector Growth Model
Growth Accounting: Objective and Technical FrameworkTFP residualDecomposing growth in GDP per workerResults
Summary of Results 16
On my webpage, you can find an example of growth accountingcomparing the UK, India and South Korea. The main result isthat
◮ GDP growth accounting:
increase in human capital (average years of education)accounts for a major part of growth in India
◮ When accounting for physical capital only, a lot of thegrowth is assigned to the residual. Keep in mind that thisresidual may have a different meaning than justtechnological progress.
If you are interested in research in economic growth, this kindof accounting exercise (including variables suspected tocontribute to growth) is a useful start.
Lecture 1.1, Exogenous Growth 16/76 Topics in Growth, Part 2
Growth AccountingThe Solow Model
Savings behaviourThe One Sector Growth Model
Model SetupBalanced Growth (with popul. and prod. growth)
From Growth Accounting to the Solow Model 17
◮ In growth accounting
→ link of inputs in period t to output in period t→ no link of inputs or output across periods (t versus t + 1)
◮ Solow model links
→ population/labor force, productivity and, in particular,capital stock in year t
to→ labor force, productivity and capital stock in year t + 1
◮ Solow (1956), Solow (1957) and Solow (1960)
Lecture 1.1, Exogenous Growth 17/76 Topics in Growth, Part 2
Growth AccountingThe Solow Model
Savings behaviourThe One Sector Growth Model
Model SetupBalanced Growth (with popul. and prod. growth)
From Growth Accounting to the Solow Model 18
◮ Solow’s story about how the capital stock evolves over time
◮ Households save → investment◮ Households save a (constant) fraction s ∈ [0, 1] of their
income every period/year◮ Households consume the rest, i.e., fraction (1 − s) of
income◮ Aggregate income : Yt◮ Aggregate investment = It = sYt
◮ Law of motion of aggregate capital (δ ∈ [0, 1])
Kt+1 = (1 − δ)Kt + It
Lecture 1.1, Exogenous Growth 18/76 Topics in Growth, Part 2
Growth AccountingThe Solow Model
Savings behaviourThe One Sector Growth Model
Model SetupBalanced Growth (with popul. and prod. growth)
Kaldor facts: Stylized facts of economic growth 19
1. The labor share and the capital share are almost constantover time.
2. The ratio of aggregate capital to output is almost constantover time.
3. The return to capital is almost constant over time.
4. Output per capita and capital per worker grow at a roughlyconstant and positive rate.
5. Different countries and regions within a country that startout with a different level of income per capita tend toconverge over time.
Lecture 1.1, Exogenous Growth 19/76 Topics in Growth, Part 2
Growth AccountingThe Solow Model
Savings behaviourThe One Sector Growth Model
Model SetupBalanced Growth (with popul. and prod. growth)
Understanding growth differences across time andacross countries 20
◮ Why do (developed) countries grow?
◮ Will developing countries catch up to developed countries?
◮ Solow model:a first attempt to explain the mechanics of growth
◮ Implications of Solow’s theory:differences in initial condition, effectiveness of labor andpopulation growth matter
Lecture 1.1, Exogenous Growth 20/76 Topics in Growth, Part 2
Growth AccountingThe Solow Model
Savings behaviourThe One Sector Growth Model
Model SetupBalanced Growth (with popul. and prod. growth)
Assumptions of the Solow model 21
◮ Assumptions
◮ Inputs: capital, Kt and labor Lt
◮ Production function: neo-classical production function
◮ Depreciation:capital depreciates at rate δ ∈ [0, 1] from t to t + 1
◮ Evolution of technology:At+1 = (1 + g)At ,
◮ Evolution of population (labor force*):Lt+1 = (1 + n)Lt
◮ where δ, g and n are exogenously given parameters
Lecture 1.1, Exogenous Growth 21/76 Topics in Growth, Part 2
Growth AccountingThe Solow Model
Savings behaviourThe One Sector Growth Model
Model SetupBalanced Growth (with popul. and prod. growth)
Assumptions of the Solow model 22
◮ Last Assumption
◮ Consumption and savings:
consumers save a constant fraction s of their income, yt ,consume fraction (1 − s) (s parameter)
◮ Per person income is: yt = rtkt + wtℓt
◮ Labor is supplied inelastically & normalized to ℓt = 1
◮ Savings per person are: syt
Lecture 1.1, Exogenous Growth 22/76 Topics in Growth, Part 2
Growth AccountingThe Solow Model
Savings behaviourThe One Sector Growth Model
Model SetupBalanced Growth (with popul. and prod. growth)
Aggregating consumers 23
◮ Savings per person are: syt = rtkt + wt
◮ Multiplying by the number of people in period t
Aggregate Savings/Investment
= It = Ltsyt = Lts(rtkt + wt) = s(rt Kt + wtLt)
Lecture 1.1, Exogenous Growth 23/76 Topics in Growth, Part 2
Growth AccountingThe Solow Model
Savings behaviourThe One Sector Growth Model
Model SetupBalanced Growth (with popul. and prod. growth)
Profit maximizing firm(s) 24
Π(K , AL) = F (K , AL)− rK − wL◮ Firms take prices as given and choose inputs K and L
◮ First order conditions
◮∂Π∂K = FK (K , AL) − r = 0
◮∂Π∂L = FL(K , AL) − w = 0
◮ Firm picks K and L such that
◮ FK (K , AL) = r
◮ FL(K , AL) = w
Lecture 1.1, Exogenous Growth 24/76 Topics in Growth, Part 2
Growth AccountingThe Solow Model
Savings behaviourThe One Sector Growth Model
Model SetupBalanced Growth (with popul. and prod. growth)
Profit maximizing firms with CD production function 25
◮ With CD production function, FOCs become
FK (K , AL) = αK α−1(AL)1−α = r
FL(K , AL) = (1 − α)K αA1−αL−α = w
◮ Or, rearranging
FK (K , AL) = α(AL
K
)1−α= r
FL(K , AL) = (1 − α)A( K
AL
)α= w
Lecture 1.1, Exogenous Growth 25/76 Topics in Growth, Part 2
Growth AccountingThe Solow Model
Savings behaviourThe One Sector Growth Model
Model SetupBalanced Growth (with popul. and prod. growth)
Euler’s Theorem with CD production function 26
rK + wL = F (K , AL)
Factor payments exhaust production.
◮ We have
r = FK (K , AL) = α(AL
K
)1−α
w = FL(K , AL) = (1 − α)A( K
AL
)α
◮ Therefore,
rK + wL = FK (K , AL)K + FL(K , AL)L
Lecture 1.1, Exogenous Growth 26/76 Topics in Growth, Part 2
Growth AccountingThe Solow Model
Savings behaviourThe One Sector Growth Model
Model SetupBalanced Growth (with popul. and prod. growth)
Euler’s Theorem with CD production function 27
◮ We had
rK + wL = FK (K , AL)K + FL(K , AL)L
◮ Therefore, substituting in functional forms for FK (K , AL)and FL(K , AL) from the previous slide, we get:
rK + wL =[
α(AL
K
)1−α]
K +[
(1 − α)A( K
AL
)α]
L
= αK α(AL)1−α + (1 − α)K α(AL)1−α
= K α(AL)1−α
= F (K , AL)
Lecture 1.1, Exogenous Growth 27/76 Topics in Growth, Part 2
Growth AccountingThe Solow Model
Savings behaviourThe One Sector Growth Model
Model SetupBalanced Growth (with popul. and prod. growth)
One large firm or many small firms 28
◮ Since firms take prices as given,◮ and assuming A and α are the same for all firms◮ from FOCs, we get
r = FK (Ki , ALi) = αA1−α( Li
Ki
)1−α
w = FL(Ki , ALi) = (1 − α)A1−α(Ki
Li
)α
◮ Capital-labor ratio, k∗ = LiKi
, chosen is the same for all firms(indexed by i).
◮ Using the CRS assumption, total output by many firms canbe represented by output of one firm
Lecture 1.1, Exogenous Growth 28/76 Topics in Growth, Part 2
Growth AccountingThe Solow Model
Savings behaviourThe One Sector Growth Model
Model SetupBalanced Growth (with popul. and prod. growth)
Law of motion of aggregate capital stock 29
◮ Using the solution to the firm’s problem, we showed that
rtKt + wtLt = F (Kt , AtLt) = Yt (lecture 2)
◮ Using the aggregation over consumers, we saw earlier
It = s(rtKt + wtLt)
◮ Therefore, It = sYt = sF (Kt , AtLt)
◮ Law of motion of aggregate capital
Kt+1 = (1 − δ)Kt + It
◮ Consider Kt+1 as a function of Kt
Lecture 1.1, Exogenous Growth 29/76 Topics in Growth, Part 2
Growth AccountingThe Solow Model
Savings behaviourThe One Sector Growth Model
Model SetupBalanced Growth (with popul. and prod. growth)
Balanced growth: n 6= 0 and g 6= 0 30
◮ Evolution of technology:At+1 = (1 + g)At ,
◮ Evolution of population (labour force*):Lt+1 = (1 + n)Lt
◮ Law of motion of aggregate capitalKt+1 = (1 − δ)Kt + sF (Kt , AtLt)
◮ Want to find growth rate of capital per worker, kt = KtLt
and
GDP per capita yt = YtLt
Lecture 1.1, Exogenous Growth 30/76 Topics in Growth, Part 2
Growth AccountingThe Solow Model
Savings behaviourThe One Sector Growth Model
Model SetupBalanced Growth (with popul. and prod. growth)
Balanced Growth: Steady state in units of effectivelabour 31
◮ Letyt = Yt
At Ltoutput per unit of effective labour
kt = KtAt Lt
capital per unit of effective labour
◮ Then we can writeytAtLt = Yt
ktAtLt = Kt
◮ Law of motion becomesKt+1 = (1 − δ)Kt + sYt or,kt+1At+1Lt+1 = (1 − δ)kt AtLt + sytAtLt
Lecture 1.1, Exogenous Growth 31/76 Topics in Growth, Part 2
Growth AccountingThe Solow Model
Savings behaviourThe One Sector Growth Model
Model SetupBalanced Growth (with popul. and prod. growth)
→ Law of Motion 32
◮ Law of motion becomes
Kt+1 = (1 − δ)Kt + sYt or,
kt+1At+1Lt+1 = (1 − δ)kt AtLt + sytAtLt or,
kt+1(1 + g)At(1 + n)Lt = (1 − δ)kt AtLt + sytAtLt
kt+1(1 + g)(1 + n) = (1 − δ)kt + syt
Lecture 1.1, Exogenous Growth 32/76 Topics in Growth, Part 2
Growth AccountingThe Solow Model
Savings behaviourThe One Sector Growth Model
Model SetupBalanced Growth (with popul. and prod. growth)
→ Law of Motion 33
◮ Law of motion for capital per unit of effective labour
kt+1 = 1(1+g)(1+n)
[
(1 − δ)kt + syt
]
◮ Note that yt = YtAt Lt
= F (Kt ,At Lt )At Lt
= kαt
Lecture 1.1, Exogenous Growth 33/76 Topics in Growth, Part 2
Growth AccountingThe Solow Model
Savings behaviourThe One Sector Growth Model
Model SetupBalanced Growth (with popul. and prod. growth)
Steady state in detrended variables(i.e. per unit of effective labour) 34
◮ Using yt = kαt , law of motion for kt
kt+1 = 1(1+g)(1+n)
[
(1 − δ)kt + skαt
]
◮ Show that kt+1 is an increasing and concave function of kt
if α, δ ∈ [0, 1], g, n ∈ [−1, 1]
Lecture 1.1, Exogenous Growth 34/76 Topics in Growth, Part 2
Growth AccountingThe Solow Model
Savings behaviourThe One Sector Growth Model
Model SetupBalanced Growth (with popul. and prod. growth)
Solow’s law of motion (capital per u. of eff. labour) 35
0
5
10
15
20
25
30
35
40
45
50
0 10 20 30 40 50K_t
K_
t+1
Kt+1 = Kt (45 degree line)
Kt+1 = (1-delta) Kt + s F(Kt,AL)
Lecture 1.1, Exogenous Growth 35/76 Topics in Growth, Part 2
Growth AccountingThe Solow Model
Savings behaviourThe One Sector Growth Model
Model SetupBalanced Growth (with popul. and prod. growth)
Solow’s law of motion (capital per u. of eff. labour) 36
0
5
10
15
20
25
30
35
40
45
50
0 10 20 30 40 50K_t
K_t+
1
Kt+1 = Kt (45 degree line)
Kt+1 = (1-delta) Kt + s F(Kt,AL)
Lecture 1.1, Exogenous Growth 36/76 Topics in Growth, Part 2
Growth AccountingThe Solow Model
Savings behaviourThe One Sector Growth Model
Model SetupBalanced Growth (with popul. and prod. growth)
Balanced Growth: Per capita/worker var’s 37
◮ Steady state ito capital per u. of eff. labour
kt+1 = 1(1+g)(1+n)
[
(1 − δ)kt + skαt
]
◮ This again can be solved for k∗, the value for which capitalper unit of effective labour does not change anymore, i.e.kt = kt+1 = k∗
* k∗ =(
sg+n+ng+δ
)1
1−α
◮ Higher population growth implies lower level of capitalstock per unit of effective labor in the long run, but growthrate of per capita variables unaffected
Lecture 1.1, Exogenous Growth 37/76 Topics in Growth, Part 2
Growth AccountingThe Solow Model
Savings behaviourThe One Sector Growth Model
Model SetupBalanced Growth (with popul. and prod. growth)
Capital per worker and GDP per capita 38
◮ When the capital stock per unit of effective labour, kt ,reaches its steady state level k∗, we get:
◮ Growth rate of capital per worker:
kt+1
kt=
Kt+1Lt+1
KtLt
=
At+1Kt+1At+1Lt+1
At KtAt Lt
=At+1k∗
At k∗
= (1 + g)
◮ Growth rate of output per capita:
yt+1
yt=
kα
t+1A1−α
t+1
kαt A1−α
t
=(kt+1
kt
)α(At+1
At
)1−α
= (1 + g)α(1 + g)1−α
= (1 + g)
Lecture 1.1, Exogenous Growth 38/76 Topics in Growth, Part 2
Growth AccountingThe Solow Model
Savings behaviourThe One Sector Growth Model
Model SetupBalanced Growth (with popul. and prod. growth)
Balanced Growth: Wage and rental rate of capital 39
◮ Growth rate of wages
wt+1
wt=
FK (t + 1)
FK (t)=
(1 − α)K αt+1(At+1Lt+1)
−αAt+1
(1 − α)K αt (AtLt)−αAt
=( k∗
k∗
)α(At+1
At
)
= (1 + g)
◮ Show that the rental rate on capital, rt ,is constant along the BGP
Lecture 1.1, Exogenous Growth 39/76 Topics in Growth, Part 2
Growth AccountingThe Solow Model
Savings behaviourThe One Sector Growth Model
Preferences, Budget constraint, Optimal choiceConsumption smoothingIntertemporal-substitution and wealth effects
Solow model and Savings Behaviour 40
Recall that in the Solow model
◮ the savings rate was an exogenous constant (parameter)
◮ therefore aggregate investment was a constant fraction ofoutput/aggregate income
Suppose you know that whatever you save, the government willtax at 100% next year. How much would you save versusconsume this year? About nothing – unless you can hide itreally well...
Hence questions such as: What is the effect of capital gainstaxes? cannot seriously be addressed in the Solow model.
However, the Solow model DID teach us that the savings rate isimportant for growth.
Lecture 1.1, Exogenous Growth 40/76 Topics in Growth, Part 2
Growth AccountingThe Solow Model
Savings behaviourThe One Sector Growth Model
Preferences, Budget constraint, Optimal choiceConsumption smoothingIntertemporal-substitution and wealth effects
A two period model of saving 41
Income
◮ Consider a household that receives an exogenous flow ofincome in each period of time
◮ We restrict the number of periods to be 2: t and t + 1
◮ Denote income in each period by yt and yt+1
◮ Assume there are perfect financial markets where thehousehold can freely borrow and lend by holding assets ordebt, at+1, at an interest rate r
Lecture 1.1, Exogenous Growth 41/76 Topics in Growth, Part 2
Growth AccountingThe Solow Model
Savings behaviourThe One Sector Growth Model
Preferences, Budget constraint, Optimal choiceConsumption smoothingIntertemporal-substitution and wealth effects
A two period model of saving 42
Preferences
◮ Preferences of the household are defined over sequencesof consumption {ct , ct+1}
◮ We assume that instantaneous utility can be representedby a standard utility function: u(c) [i.e. u(.) is increasing,twice differentiable, concave and satisfies Inadaconditions*]
◮ Life-time utility is the discounted sum of instantaneousutilities → The agent has a subjective rate of timepreference ρ so that the discount factor is 1/(1 + ρ) < 1→ high ρ means impatient→ low ρ means patient
Lecture 1.1, Exogenous Growth 42/76 Topics in Growth, Part 2
Growth AccountingThe Solow Model
Savings behaviourThe One Sector Growth Model
Preferences, Budget constraint, Optimal choiceConsumption smoothingIntertemporal-substitution and wealth effects
A two period model of saving 43
Preferences
◮ Life-time utility is
V (ct , ct+1) = u(ct) +1
1 + ρu(ct+1)
◮ Sometimes we will define β ≡ 11+ρ and write utility as
V (ct , ct+1) = u(ct) + βu(ct + 1)
β is the discount factor
Lecture 1.1, Exogenous Growth 43/76 Topics in Growth, Part 2
Growth AccountingThe Solow Model
Savings behaviourThe One Sector Growth Model
Preferences, Budget constraint, Optimal choiceConsumption smoothingIntertemporal-substitution and wealth effects
A two period model of saving 44
Budget constraint
◮ The agent faces two period-by-period constraints
ct + at+1 = yt
ct+1 = yt+1 + (1 + r)at+1
◮ The assumption of perfect financial markets means thatconsumption is not restricted to equal income
◮ Agent can allocate consumption in many different ways
◮ In fact, he faces a single constraint:
the intertemporal budget constraint
◮ It follows from aggregating over time as follows:
ct + 11+r ct+1 = yt + 1
1+r yt+1Lecture 1.1, Exogenous Growth 44/76 Topics in Growth, Part 2
Growth AccountingThe Solow Model
Savings behaviourThe One Sector Growth Model
Preferences, Budget constraint, Optimal choiceConsumption smoothingIntertemporal-substitution and wealth effects
A two period model of saving 45
Budget constraint
◮ It follows from aggregating over time that:
ct + 11+r ct+1 = yt + 1
1+r yt+1
◮ In other words, the present value of consumption cannotexceed the present value of income (or wealth)
◮ This can be represented graphically*
◮ Only at the point corresponding to the endowment, saving(borrowing (-) or lending (+)) is zero
Lecture 1.1, Exogenous Growth 45/76 Topics in Growth, Part 2
Growth AccountingThe Solow Model
Savings behaviourThe One Sector Growth Model
Preferences, Budget constraint, Optimal choiceConsumption smoothingIntertemporal-substitution and wealth effects
Household’s optimization problem 46
Given yt , yt+1 and r
maxct ,ct+1
u(ct) + βu(ct+1)
s.t. ct +1
1 + rct+1 = yt +
11 + r
yt+1
or, equivalently,
maxct ,ct+1
u(ct) + βu(ct+1)
s.t. ct + at+1 = yt
ct+1 = (1 + r)at+1 + yt+1
Lecture 1.1, Exogenous Growth 46/76 Topics in Growth, Part 2
Growth AccountingThe Solow Model
Savings behaviourThe One Sector Growth Model
Preferences, Budget constraint, Optimal choiceConsumption smoothingIntertemporal-substitution and wealth effects
Solution to the optimization problem 47
Graphical solution*
◮ Using the first formulation, the problem and the solutioncan be represented in the typical indifference-curvediagram on the (ct , ct+1) - space
◮ The optimal choice is characterized by the allocation wherethe intertemporal budget constraint (with slope −(1 + r)) istangent to an indifference curve
Lecture 1.1, Exogenous Growth 47/76 Topics in Growth, Part 2
Growth AccountingThe Solow Model
Savings behaviourThe One Sector Growth Model
Preferences, Budget constraint, Optimal choiceConsumption smoothingIntertemporal-substitution and wealth effects
Solution to the optimization problem 48
Analytical solution
◮ This solution is characterized by a FOC and the budgetconstraint (2 equations for 2 unknowns (ct , ct+1))
◮ The FOC reads,
u′(ct) =1 + r1 + ρ
u′(ct+1)
= β(1 + r)u′(ct+1)
◮ This is called the Euler equation
Lecture 1.1, Exogenous Growth 48/76 Topics in Growth, Part 2
Growth AccountingThe Solow Model
Savings behaviourThe One Sector Growth Model
Preferences, Budget constraint, Optimal choiceConsumption smoothingIntertemporal-substitution and wealth effects
Consumption smoothing 49
◮ The FOC implies that the change in consumption over timedepends entirely on the form of the utility function, u(.), ρand r
◮ The time-profile of income does not matter for thetime-profile of consumption (holding present value oflife-time income fixed)
◮ The present value of income is only important indetermining the level consumption in the two periods, butnot the steepness of the consumption path
Lecture 1.1, Exogenous Growth 49/76 Topics in Growth, Part 2
Growth AccountingThe Solow Model
Savings behaviourThe One Sector Growth Model
Preferences, Budget constraint, Optimal choiceConsumption smoothingIntertemporal-substitution and wealth effects
Consumption smoothing 50
◮ Consider in particular the situation where interest rateequals the rate of time preference: r = ρ
◮ In this case, consumption is the same in the two periodseven if income is not
◮ This captures the implication of concave utility functions forconsumption: agents tend to prefer smooth consumptionpaths
◮ They can do that because they can borrow and lend
◮ To see more specifically how the interest rate can alter theoptimal path of consumption, it proves convenient to use aspecific yet fairly general form for the utility function...
Lecture 1.1, Exogenous Growth 50/76 Topics in Growth, Part 2
Growth AccountingThe Solow Model
Savings behaviourThe One Sector Growth Model
Preferences, Budget constraint, Optimal choiceConsumption smoothingIntertemporal-substitution and wealth effects
Constant-elasticity-of-substitution utility 51
◮ We use the following,
u(c) =c1−σ
1 − σif σ 6= 1
= log c if σ = 1
◮ It turns out that σ determines the household’s willingnessto shift consumption across periods:→ the smaller is σ,→ the more slowly marginal utility ↓ as consumption ↑→ the more willing is the household to allow itsconsumption to vary over time (if r differs from ρ)
Lecture 1.1, Exogenous Growth 51/76 Topics in Growth, Part 2
Growth AccountingThe Solow Model
Savings behaviourThe One Sector Growth Model
Preferences, Budget constraint, Optimal choiceConsumption smoothingIntertemporal-substitution and wealth effects
Constant-elasticity-of-substitution utility 52
◮ This can be seen from the FOC,
u′(ct ) =1 + r1 + ρ
u′(ct+1)
◮ Using the CES utility function*,
ct+1
ct=
(1 + r1 + ρ
)1σ
◮ If σ is close to zero, then utility is close to linear and thehousehold is willing to accept large swings in consumptionto take advantage of small differences between ρ and r
Lecture 1.1, Exogenous Growth 52/76 Topics in Growth, Part 2
Growth AccountingThe Solow Model
Savings behaviourThe One Sector Growth Model
Preferences, Budget constraint, Optimal choiceConsumption smoothingIntertemporal-substitution and wealth effects
Constant-elasticity-of-substitution utility 53
◮ In fact the intertemporal elasticity of substitution, IES, isclosely related to σ
◮ The IES is defined as
θ(c) = − u′(c)u′′(c)c
◮ This is essentially a measure of the curvature of the utilityfunctions and, therefore, of the willingness to acceptswings in consumption over time
◮ With the CES utility function, the IES becomes*
θ(c) = − u′(c)u′′(c)c = 1/σ
Lecture 1.1, Exogenous Growth 53/76 Topics in Growth, Part 2
Growth AccountingThe Solow Model
Savings behaviourThe One Sector Growth Model
Preferences, Budget constraint, Optimal choiceConsumption smoothingIntertemporal-substitution and wealth effects
Intertemporal-substitution and wealth effects 54
Intertemporal substitution and r
◮ θ = 1/σ determines the responsiveness of the slope of theconsumption path to changes in the interest rate
◮ Higher r implies that optimal consumption grows fasterover time
◮ This does not depend on the time path of income
◮ This is the intertemporal-substitution effect of a change inthe interest rate → (1 + r) is just the relative price of ct interms of ct+1
Lecture 1.1, Exogenous Growth 54/76 Topics in Growth, Part 2
Growth AccountingThe Solow Model
Savings behaviourThe One Sector Growth Model
Preferences, Budget constraint, Optimal choiceConsumption smoothingIntertemporal-substitution and wealth effects
Intertemporal-substitution and wealth effects 55
Intertemporal substitution and r
◮ Thus intertemporal substitution is the standard substitutioneffect when the relative price of two commodities changes
◮ This effect of an increase in r tends to increase savinga = yt − ct
Lecture 1.1, Exogenous Growth 55/76 Topics in Growth, Part 2
Growth AccountingThe Solow Model
Savings behaviourThe One Sector Growth Model
Preferences, Budget constraint, Optimal choiceConsumption smoothingIntertemporal-substitution and wealth effects
Intertemporal-substitution and wealth effects 56
Wealth effect and r
◮ But, as usual, there is also a wealth effect
◮ Here, it is useful to draw the indifference-curve diagram
◮ If initially saving is zero, then the wealth effect is nil and thesubstitution effect dictates an increase in saving
◮ If initially the household is borrowing, both the wealth andsubstitution effects go in the direction of increasing saving(or reducing borrowing)
◮ If the household is initially saving, then the wealth effecttends to reduce saving and the net effect is ambiguous
◮ Follow graphical analysis and discussion in D.Romer(1996,p325-327)].
Lecture 1.1, Exogenous Growth 56/76 Topics in Growth, Part 2
Growth AccountingThe Solow Model
Savings behaviourThe One Sector Growth Model
Preferences, Budget constraint, Optimal choiceConsumption smoothingIntertemporal-substitution and wealth effects
Intertemporal-substitution and wealth effects 57
Savings is a = yt − ct
Suppose r increases
◮ Substitution effect ⇒ a ↑
◮ Income effect ⇒ a ?
◮ If initially a = 0, no wealth effect ⇒ a ↑
◮ If initially a > 0, positive wealth effect ⇒ a ?
◮ If initially a < 0, negative wealth effect ⇒ a ↑
Lecture 1.1, Exogenous Growth 57/76 Topics in Growth, Part 2
Growth AccountingThe Solow Model
Savings behaviourThe One Sector Growth Model
Main Ingredients of the ModelDefinition of EquilibriumSteady state and Dynamics
The One Sector Growth Model 58
Main Ingredients
◮ Neoclassical model of the firm
◮ Consumption-savings choice for consumers
◮ “Solow model + incentives to save”
(recall example with taxes)
Lecture 1.1, Exogenous Growth 58/76 Topics in Growth, Part 2
Growth AccountingThe Solow Model
Savings behaviourThe One Sector Growth Model
Main Ingredients of the ModelDefinition of EquilibriumSteady state and Dynamics
The 1SGM 59
Markets and ownership
Agents◮ Firms produce goods, hire labor and rent capital◮ Households own labor and assets (capital),
receive wages and rental payments, consume and save
Markets◮ Inputs: competitive wage rates, w , and rental rate, R◮ Assets: free borrowing and lending at interest rate, r◮ Output: competitive market for consumption good
Lecture 1.1, Exogenous Growth 59/76 Topics in Growth, Part 2
Growth AccountingThe Solow Model
Savings behaviourThe One Sector Growth Model
Main Ingredients of the ModelDefinition of EquilibriumSteady state and Dynamics
The 1SGM 60
Firms / Representative Firm
Seeks to maximize profits
Profit = F (K , L) − RK − wL
The FOCs for this problem deliver
∂F∂K
= R∂F∂L
= w
In per unit of labor terms, let f (k) ≡ F (k , 1)
f ′(k) = R f (k) − kf ′(k) = w
Recall Euler’s Theorem: factor payments exhaust outputLecture 1.1, Exogenous Growth 60/76 Topics in Growth, Part 2
Growth AccountingThe Solow Model
Savings behaviourThe One Sector Growth Model
Main Ingredients of the ModelDefinition of EquilibriumSteady state and Dynamics
The 1SGM 61
Households / Representative household
Preferences
U0 =
∞∑
t=0
βtu(ct)
Budget constraint
ct + at+1 = wt + (1 + r)at ,
for all t = 0, 1, 2, ...
a0 given
Note: labor supplied inelastically, lt = 1
Lecture 1.1, Exogenous Growth 61/76 Topics in Growth, Part 2
Growth AccountingThe Solow Model
Savings behaviourThe One Sector Growth Model
Main Ingredients of the ModelDefinition of EquilibriumSteady state and Dynamics
The 1SGM 62
Households / Representative household
Intertemporal version of budget constraint
∞∑
t=0
t∏
s=0
(
11 + rs
)
ct = a0 +
∞∑
t=0
t∏
s=0
(
11 + rs
)
wt
We rule out that debt explodes (no Ponzi games)
at+1 ≥ −B for some B big, but finite
More compactly, PDV (c) = a(0) + PDV (w)
Lecture 1.1, Exogenous Growth 62/76 Topics in Growth, Part 2
Growth AccountingThe Solow Model
Savings behaviourThe One Sector Growth Model
Main Ingredients of the ModelDefinition of EquilibriumSteady state and Dynamics
The 1SGM 63
Household’s problem
max(at+1,ct )
∞
t=0
∞∑
t=0
βtu(ct)
s.t.
ct + at+1 = wt + (1 + r)at , for all t = 0, 1, 2, ...
at+1 = −B for some B big, but finite
a0 given
Lecture 1.1, Exogenous Growth 63/76 Topics in Growth, Part 2
Growth AccountingThe Solow Model
Savings behaviourThe One Sector Growth Model
Main Ingredients of the ModelDefinition of EquilibriumSteady state and Dynamics
The 1SGM 64
Euler equationIn general,
u′(ct) = β(1 + rt+1)u′(ct+1)
From here on, CES utility, u(c) = c1−σ
1−σ , Euler eqn. becomes,
(
ct+1
ct
)σ
= β(1 + rt+1)
Lecture 1.1, Exogenous Growth 64/76 Topics in Growth, Part 2
Growth AccountingThe Solow Model
Savings behaviourThe One Sector Growth Model
Main Ingredients of the ModelDefinition of EquilibriumSteady state and Dynamics
The 1SGM 65
Transversality conditionHH do not want to “end up” with positive values of assets
limt→∞
βtu′(ct)at ≥ 0
HH cannot think they can borrow at the “end of their life”
limt→∞
βtu′(ct)at ≤ 0
Hence,
limt→∞
βtu′(ct)at = 0
Lecture 1.1, Exogenous Growth 65/76 Topics in Growth, Part 2
Growth AccountingThe Solow Model
Savings behaviourThe One Sector Growth Model
Main Ingredients of the ModelDefinition of EquilibriumSteady state and Dynamics
Definition of Equilibrium 66
A competitive equilibrium is defined by sequences of quantitiesof consumption, {ct}, capital, {kt}, and output, {yt}, andsequences of prices, {wt} and {rt}, such that
◮ Firms maximize profits
◮ Households maximize U0 subject to their constraints
◮ Goods, labour and asset markets clear
Lecture 1.1, Exogenous Growth 66/76 Topics in Growth, Part 2
Growth AccountingThe Solow Model
Savings behaviourThe One Sector Growth Model
Main Ingredients of the ModelDefinition of EquilibriumSteady state and Dynamics
Benevolent planner’s problem* 67
What is the allocation of resources that an economy shouldfeature in order to attain the highest feasible level of utility?
Central Planner’s optimal choice problem
max(kt+1,ct)
∞
t=0
∞∑
t=0
βtu(ct)
s.t.
ct + kt+1 = f (kt) + (1 − δ)kt , for all t = 0, 1, 2, ...
k0 > 0 given
Lecture 1.1, Exogenous Growth 67/76 Topics in Growth, Part 2
Growth AccountingThe Solow Model
Savings behaviourThe One Sector Growth Model
Main Ingredients of the ModelDefinition of EquilibriumSteady state and Dynamics
Benevolent planner’s problem 68
Welfare
Socially optimal allocation coincides with the equilibriumallocation.
The competitive equilibrium leads to the social optimum.
Not surprising: no distortions or externalities→ Welfare Theorems hold
Lecture 1.1, Exogenous Growth 68/76 Topics in Growth, Part 2
Growth AccountingThe Solow Model
Savings behaviourThe One Sector Growth Model
Main Ingredients of the ModelDefinition of EquilibriumSteady state and Dynamics
Steady state* 69
Definition
A balanced growth path (BGP) is a situation in which output,capital and consumption grow at a constant rate.
If this constant rate is zero, it is called a steady state.
We can usually redefine the state variable so that the latter isconstant (i.e. the growth rate is zero)
Recall from the Solow model:
capital per capita for n = 0, g = 0 capital per unit of effectivelabor for n > 0, g > 0
Lecture 1.1, Exogenous Growth 69/76 Topics in Growth, Part 2
Growth AccountingThe Solow Model
Savings behaviourThe One Sector Growth Model
Main Ingredients of the ModelDefinition of EquilibriumSteady state and Dynamics
Steady state 70
From the Euler equation,
ct+1
ct= [β(1 + f ′(kt+1) − δ)]1/σ , for all t
If consumption grows at a constant rate (BGP), say γ
1 + γ = [β(1 + f ′(kt+1) − δ)]1/σ , for all t
Thus RHS must be constant→ kt+1 = kt = k∗ must be constant along the BGP
Lecture 1.1, Exogenous Growth 70/76 Topics in Growth, Part 2
Growth AccountingThe Solow Model
Savings behaviourThe One Sector Growth Model
Main Ingredients of the ModelDefinition of EquilibriumSteady state and Dynamics
Steady state 71
But then, from the resource constraint with kt = kt+1 = k∗:
ct + kt+1 = f (kt) + (1 − δ)kt , for all t
i.e.,ct = f (k∗) − δk∗
ct+1 = f (k∗) − δk∗
We find that consumption must be constant along the BGP,→ ct+1 = ct = c∗ or γ = 0
Hence we have a steady state in per capita variables.
Lecture 1.1, Exogenous Growth 71/76 Topics in Growth, Part 2
Growth AccountingThe Solow Model
Savings behaviourThe One Sector Growth Model
Main Ingredients of the ModelDefinition of EquilibriumSteady state and Dynamics
Steady state* 72
Hence from the Euler equation
1 + γ = 1 = [β(1 + f ′(k∗) − δ)]1/σ
or, simplified
f ′(k∗) =1β− (1 − δ) = ρ + δ
we can solve for k∗and from the (simplified) resource constraint
c∗ = f (k∗) − δk∗
we can solve for c∗
Lecture 1.1, Exogenous Growth 72/76 Topics in Growth, Part 2
Growth AccountingThe Solow Model
Savings behaviourThe One Sector Growth Model
Main Ingredients of the ModelDefinition of EquilibriumSteady state and Dynamics
Off steady state dynamics* 73
Off the steady state, consumption and capital adjust to reachthe steady state eventually.
To analyze these dynamics, consider the movements of c and kseparately.
Let ∆c = ct+1 − ct and ∆k = kt+1 − kt . See graphical analysis.
Lecture 1.1, Exogenous Growth 73/76 Topics in Growth, Part 2
Growth AccountingThe Solow Model
Savings behaviourThe One Sector Growth Model
Main Ingredients of the ModelDefinition of EquilibriumSteady state and Dynamics
Off steady state dynamics* 74
◮ Consider the set of points such that ∆c = 0, then from theEuler eqn, the optimal k satisfies f ′(k) = ρ + δ
→ draw vertical line at k∗(< kGR)
To the left: kt < k∗ ⇒ f ′(kt) > f ′(k∗) ⇒ ∆c > 0 ⇒ c ↑To the right: kt > k∗ ⇒ f ′(kt) < f ′(k∗) ⇒ ∆c < 0 ⇒ c ↓
◮ Consider the set of points such that ∆k = 0, then from theResource cstrt, the optimal c satisfies c = f (k) − δk
→ draw hump-shaped line from origin, maximized at kGR
cross 0 again for k such that f (k) = δk
Above: ct > f (kt) − δkt ⇒ ∆k = f (kt ) − δkt − ct < 0 ⇒ k ↓Below: ct < f (kt) − δkt ⇒ ∆k = f (kt) − δkt − ct > 0 ⇒ k ↑
Lecture 1.1, Exogenous Growth 74/76 Topics in Growth, Part 2
Growth AccountingThe Solow Model
Savings behaviourThe One Sector Growth Model
Main Ingredients of the ModelDefinition of EquilibriumSteady state and Dynamics
Adding population and productivity growth 75
◮ Evolution of technology:At+1 = (1 + g)At ,
◮ Evolution of population (labour force*):Lt+1 = (1 + n)Lt
◮ Resource constraint in units of effective labourct + (1 + n)(1 + g)kt+1 = (1 − δ)kt + f (kt)
◮ Euler equation in units of effective labour becomes
ct+1ct
=[β(1+f ′(kt+1)−δ)]
1σ
(1+n)(1+g)
Lecture 1.1, Exogenous Growth 75/76 Topics in Growth, Part 2
Growth AccountingThe Solow Model
Savings behaviourThe One Sector Growth Model
Main Ingredients of the ModelDefinition of EquilibriumSteady state and Dynamics
Balanced Growth: St. state in units of effective labour76
◮ In steady state:ct+1ct
= 1 and kt+1
kt= 1
◮ Solving the Euler Equation for k∗ gives
k∗ =
[
βα
((1 + n)(1 + g))σ − (1 − δ)β
]
decreasing in population growth rate. But long run growthrates of per capita variables are independent of n
◮ Thus, in terms of population growth rates, One SectorGrowth Model gives same conclusions as Solow model.
Lecture 1.1, Exogenous Growth 76/76 Topics in Growth, Part 2