Topic 1: Ireland’s long-run Topic 1: Ireland’s long-run economic performanceeconomic performance

ReadingsReadings Abel & Bernanke or other macro Abel & Bernanke or other macro

textbooktextbook Chapter on long-run economic growthChapter on long-run economic growth

Solow model and convergenceSolow model and convergence

Honohan and Walsh (2002)Honohan and Walsh (2002)

Blanchard (2002)Blanchard (2002)

The Solow Growth ModelThe Solow Growth Model

Also known as the “neoclassical” growth modelAlso known as the “neoclassical” growth model

Interactive experiments available at:Interactive experiments available at:

http://www.fgn.unisg.ch/eurmacro/tutor/http://www.fgn.unisg.ch/eurmacro/tutor/solow_index.htmlsolow_index.html

Cobb-Douglas production Cobb-Douglas production functionfunction

Y = A F(K, L) = A KY = A F(K, L) = A K L L(1-(1-))

Y = OutputY = Output

A = Total Factor Productivity (TFP)A = Total Factor Productivity (TFP)

K = Capital inputK = Capital input

L = Labour inputL = Labour input

TFP (A)TFP (A)

A: Also called the “Solow residual”A: Also called the “Solow residual” Captures wide range of factors:Captures wide range of factors:

State of technologyState of technology Strength of economic and political Strength of economic and political

institutionsinstitutions Input utilizationInput utilization Sectoral composition of outputSectoral composition of output Other stuffOther stuff

Sectoral composition of outputSectoral composition of output

A = economy-wide level of productivityA = economy-wide level of productivity Consider an economy with two sectors:Consider an economy with two sectors:

1. Agriculture = low productivity1. Agriculture = low productivity 2. Manufacturing = high productivity2. Manufacturing = high productivity

If Agriculture shrinks and Manufacturing If Agriculture shrinks and Manufacturing grows, then A increasesgrows, then A increases

= elasticity of Y w.r.t. K= elasticity of Y w.r.t. K

Exercise 1: Prove it!Exercise 1: Prove it!

Also:Also: = capital’s share of output (1<= capital’s share of output (1<<0)<0)

Exercise 2: Prove it!Exercise 2: Prove it!

Per worker versionPer worker version

divide by Ldivide by L y = Af(k) = A ky = Af(k) = A k

where where y = Y/Ly = Y/Lk = K/Lk = K/L

Exercise 3: Prove it!Exercise 3: Prove it!

Law of motion for the capital stock:Law of motion for the capital stock:

kkt+1t+1 = (1- = (1-) k) ktt + i + itt

Where: Where: i = investmenti = investment

= rate of depreciation= rate of depreciation

What happens to the capital stock ifWhat happens to the capital stock if

iitt = = kktt

kkt+1t+1 = (1- = (1-) k) ktt + i + ittkkt+1t+1 = k = ktt - - kktt + i + itt

kkt+1t+1 = k = ktt

Let Let k* = steady-state capital stockk* = steady-state capital stock

y* = Af(k*) = steady-state outputy* = Af(k*) = steady-state output

If iIf itt > > kkt t then capital stock is then capital stock is growinggrowing

If iIf itt < < kkt t then capital stock is then capital stock is shrinkingshrinking

In a closed economy:In a closed economy:

Investment = SavingsInvestment = Savings

i = syi = sy

i = sAf(k)i = sAf(k)

where s = savings ratewhere s = savings rate

ConvergenceConvergence

Conditional convergenceConditional convergence If two countries have the similar A and s, If two countries have the similar A and s,

but different initial k, then they will but different initial k, then they will converge converge

If a SOE, then s not importantIf a SOE, then s not important Absent obstacles, A’s shouldn’t be very Absent obstacles, A’s shouldn’t be very

different across advanced economiesdifferent across advanced economies Evidence of conditional convergence Evidence of conditional convergence

among advanced economiesamong advanced economies

Honohan and Walsh (2002)Honohan and Walsh (2002)

1990s boom was a convergence story1990s boom was a convergence story Convergence telescoped into one decadeConvergence telescoped into one decade

No single factor accounts for 1990s No single factor accounts for 1990s boomboom

Why didn’t Ireland converge sooner?Why didn’t Ireland converge sooner? Institutional preconditions for such Institutional preconditions for such

convergence already present in 1973, but convergence already present in 1973, but fiscal policy errors in the 1970s derailed fiscal policy errors in the 1970s derailed convergenceconvergence

Honohan and Walsh (2002)Honohan and Walsh (2002)

Why was convergence in the 1990s Why was convergence in the 1990s so rapid?so rapid? How do we explain the employment How do we explain the employment

boom? boom?

Non-agricultural employment as share of population

20

25

30

35

40

60 65 70 75 80 85 90 95 00

Source: Honohan and Walsh (2002)Source: Honohan and Walsh (2002)

Table 1: Ireland’s employment share and productivity relative to UK, 1973

Ireland UK Ireland

As % of UK Apparent Productivity (£ per head) GDP per person at work 2 380 2 642 90 Agricultural output per person at work 1 634 2 726 60 Non-agricultural output per person at work 2 605 2 640 99 GDP per head of population 856 1 173 73 Employment shares (%) Employment in agriculture as % total 23.2 3.0 780 Total employment as % population 36.0 44.4 81 Non-agricultural employment as % population 27.6 43.1 64 Source: Ireland: ESRI database; UK: Annual Abstract of Statistics, 1985 edition; OECD National Income Accounts. Note: “Agriculture” includes forestry and fisheries. The difference between GDP and GNP in 1973 was small.

Source: Honohan and Walsh (2002)Source: Honohan and Walsh (2002)

Fiscal ErrorsFiscal Errors

See Figure 3: Budgetary Aggregates See Figure 3: Budgetary Aggregates

See Figure 4: Marginal and Average See Figure 4: Marginal and Average Income Tax Rates, 1979-2002Income Tax Rates, 1979-2002

Unfavorable external Unfavorable external conditionsconditions

Table 2: External conditions in the 1980s

UK GDP Growth % per annum

US $ short interest rate

%

1981-84 1.8 12.0

1986-89 4.1 7.6

Source: Honohan and Walsh (2002)Source: Honohan and Walsh (2002)

Blanchard (2002)Blanchard (2002)• Key factor behind boom: Wage Key factor behind boom: Wage

moderationmoderation• Wage moderation = “wage growth Wage moderation = “wage growth

below the rate consistent with below the rate consistent with technological progress.”technological progress.”

• Low wage growth Low wage growth lower costs lower costs higher profits higher profits higher K and L higher K and L

Blanchard (2002)Blanchard (2002)

Recall: Y = A F(K, L) = A KRecall: Y = A F(K, L) = A K L L(1-(1-))

Marginal product of labour (MPL)Marginal product of labour (MPL)

MPL = MPL = Y/Y/L = (1-L = (1-)A F(K, L)/L)A F(K, L)/L

From micro, we know that firms choose From micro, we know that firms choose L to equate the MPL to the market wage L to equate the MPL to the market wage raterate

So, for the whole economy:So, for the whole economy:

w = (1-w = (1-)A F(K, L)/L)A F(K, L)/L

w/A = (1-w/A = (1-) F(K, L)/L) F(K, L)/L

w/A = (1-w/A = (1-) (K/L)) (K/L)

Exercise 4: Prove it!Exercise 4: Prove it! If w/A falls, thenIf w/A falls, then

K/L must fallK/L must fall But K rises due to higher profitsBut K rises due to higher profits So L must boom!So L must boom!

Ireland, Wage rate of the business sector, EUR

c.o.p 1 year

Source: EcoWin

78 80 82 84 86 88 90 92 94 96 98 00 02 04 06

Perc

en

t

0.0

2.5

5.0

7.5

10.0

12.5

15.0

17.5

20.0

Ireland, Unit labour cost of the total economy, EUR

c.o.p 1 year

Source: EcoWin

60 65 70 75 80 85 90 95 00 05

Pe

rce

nt

-2.5

0.0

2.5

5.0

7.5

10.0

12.5

15.0

17.5

20.0

22.5

So wage restraint boosts So wage restraint boosts investment and especially investment and especially employmentemployment

Sources of wage restraintSources of wage restraint Social partnership agreementsSocial partnership agreements High unemploymentHigh unemployment Natural demographicsNatural demographics ImmigrationImmigration Income tax cutsIncome tax cuts

Why did wage moderation have Why did wage moderation have such a large effect in Ireland?such a large effect in Ireland? Openness of economyOpenness of economy

Notable amount of Notable amount of K took the K took the form of Foreign Direct Investment form of Foreign Direct Investment (FDI)(FDI)

Migration flows Migration flows Available export marketsAvailable export markets

No “crowding out”No “crowding out”

Reading for next lectureReading for next lecture Ahearne, Kydland, and Wynne Ahearne, Kydland, and Wynne

(2005)(2005) Barry (2002)Barry (2002) Fitz Gerald (2004)Fitz Gerald (2004)