If you have ever spoken with your grandparents about what their lives were like

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1 CHAPTER 7 Economic Growth I: Capital Accumulation an Population Growth The question of growth is nothing new but a new isguise for an age-ol issue, one which has always intrigue an preoccupie economics: the present versus the future. James Tobin If you have ever spoken with your granparents about what their lives were like when they were young, most likely you learne an important lesson about economic growth: material stanars of living have improve substantially over time for most families in most countries. This avance comes from rising incomes, which have allowe people to consume greater quantities of goos an services. To measure economic growth, economists use ata on gross omestic prouct, which measures the total income of everyone in the economy. The real GDP of the Unite States toay is more than five times its 1950 level, an real GDP per person is more than three times its 1950 level. In any given year, we also observe large ifferences in the stanar of living among countries. Table 7-1 shows the 2007 income per person in the worl s 14 most populous countries. The Unite States tops the list with an income of $45,790 per person. Banglaesh has an income per person of only $1,242 less than 3 percent of the figure for the Unite States. Our goal in this part of the book is to unerstan what causes these ifferences in income over time an across countries. In Chapter 3 we ientifie the factors of prouction capital an labor an the prouction technology as the sources of the economy s output an, thus, of its total income. Differences in income, then, must come from ifferences in capital, labor, an technology. Our primary task in this chapter an the next is to evelop a theory of economic growth calle the Solow growth moel. Our analysis in Chapter 3 enable us to escribe how the economy prouces an uses its output at one point in time. The analysis was static a snapshot of the economy. To explain why our national income grows, an why some economies grow faster than others, we must broaen our analysis so that it escribes changes in the economy over time. By eveloping such a moel, we make our analysis ynamic more like a 191

2 192 PART III Growth Theory: The Economy in the Very Long Run TABLE 7-1 Income per Income per Country person (2007) Country person (2007) Unite States $45,790 Inonesia 3,728 Japan 33,525 Philippines 3,410 Germany 33,154 Inia 2,753 Russia 14,743 Vietnam 2,600 Mexico 12,780 Pakistan 2,525 Brazil 9,570 Nigeria 1,977 China 5,345 Banglaesh 1,242 Source: The Worl Bank. International Differences in the Stanar of Living movie than a photograph. The Solow growth moel shows how saving, population growth, an technological progress affect the level of an economy s output an its growth over time. In this chapter we analyze the roles of saving an population growth. In the next chapter we introuce technological progress The Accumulation of Capital The Solow growth moel is esigne to show how growth in the capital stock, growth in the labor force, an avances in technology interact in an economy as well as how they affect a nation s total output of goos an services. We will buil this moel in a series of steps. Our first step is to examine how the supply an eman for goos etermine the accumulation of capital. In this first step, we assume that the labor force an technology are fixe. We then relax these assumptions by introucing changes in the labor force later in this chapter an by introucing changes in technology in the next. The Supply an Deman for Goos The supply an eman for goos playe a central role in our static moel of the close economy in Chapter 3. The same is true for the Solow moel. By consiering the supply an eman for goos, we can see what etermines how 1 The Solow growth moel is name after economist Robert Solow an was evelope in the 1950s an 1960s. In 1987 Solow won the Nobel Prize in economics for his work on economic growth. The moel was introuce in Robert M. Solow, A Contribution to the Theory of Economic Growth, Quarterly Journal of Economics (February 1956):

3 CHAPTER 7 Economic Growth I: Capital Accumulation an Population Growth 193 much output is prouce at any given time an how this output is allocate among alternative uses. The Supply of Goos an the Prouction Function The supply of goos in the Solow moel is base on the prouction function, which states that output epens on the capital stock an the labor force: Y = F(K, L). The Solow growth moel assumes that the prouction function has constant returns to scale. This assumption is often consiere realistic, an, as we will see shortly, it helps simplify the analysis. Recall that a prouction function has constant returns to scale if zy = F(zK, zl) for any positive number z. That is, if both capital an labor are multiplie by z, the amount of output is also multiplie by z. Prouction functions with constant returns to scale allow us to analyze all quantities in the economy relative to the size of the labor force. To see that this is true, set z = 1/L in the preceing equation to obtain Y/L = F(K/L, 1). This equation shows that the amount of output per worker Y/L is a function of the amount of capital per worker K/L. (The number 1 is constant an thus can be ignore.) The assumption of constant returns to scale implies that the size of the economy as measure by the number of workers oes not affect the relationship between output per worker an capital per worker. Because the size of the economy oes not matter, it will prove convenient to enote all quantities in per worker terms. We esignate quantities per worker with lowercase letters, so y = Y/L is output per worker, an k = K/L is capital per worker. We can then write the prouction function as y = f(k), where we efine f(k) = F(k, 1). Figure 7-1 illustrates this prouction function. The slope of this prouction function shows how much extra output a worker prouces when given an extra unit of capital. This amount is the marginal prouct of capital MPK. Mathematically, we write MPK = f(k + 1) f(k). Note that in Figure 7-1, as the amount of capital increases, the prouction function becomes flatter, inicating that the prouction function exhibits iminishing marginal prouct of capital. When k is low, the average worker has only a little capital to work with, so an extra unit of capital is very useful an prouces a lot of aitional output. When k is high, the average worker has a lot of capital alreay, so an extra unit increases prouction only slightly.

4 194 PART III Growth Theory: The Economy in the Very Long Run FIGURE 7-1 Output per worker, y 1 MPK Output, f(k) The Prouction Function The prouction function shows how the amount of capital per worker k etermines the amount of output per worker y = f(k). The slope of the prouction function is the marginal prouct of capital: if k increases by 1 unit, y increases by MPK units. The prouction function becomes flatter as k increases, inicating iminishing marginal prouct of capital. Capital per worker, k The Deman for Goos an the Consumption Function The eman for goos in the Solow moel comes from consumption an investment. In other wors, output per worker y is ivie between consumption per worker c an investment per worker i: y = c + i. This equation is the per-worker version of the national income accounts ientity for an economy. Notice that it omits government purchases (which for present purposes we can ignore) an net exports (because we are assuming a close economy). The Solow moel assumes that each year people save a fraction s of their income an consume a fraction (1 s). We can express this iea with the following consumption function: c = (1 s)y, where s, the saving rate, is a number between zero an one. Keep in min that various government policies can potentially influence a nation s saving rate, so one of our goals is to fin what saving rate is esirable. For now, however, we just take the saving rate s as given. To see what this consumption function implies for investment, substitute (1 s)y for c in the national income accounts ientity: Rearrange the terms to obtain y = (1 s)y + i. i = sy.

5 CHAPTER 7 Economic Growth I: Capital Accumulation an Population Growth 195 This equation shows that investment equals saving, as we first saw in Chapter 3. Thus, the rate of saving s is also the fraction of output evote to investment. We have now introuce the two main ingreients of the Solow moel the prouction function an the consumption function which escribe the economy at any moment in time. For any given capital stock k, the prouction function y = f(k) etermines how much output the economy prouces, an the saving rate s etermines the allocation of that output between consumption an investment. Growth in the Capital Stock an the Steay State At any moment, the capital stock is a key eterminant of the economy s output, but the capital stock can change over time, an those changes can lea to economic growth. In particular, two forces influence the capital stock: investment an epreciation. Investment is expeniture on new plant an equipment, an it causes the capital stock to rise. Depreciation is the wearing out of ol capital, an it causes the capital stock to fall. Let s consier each of these forces in turn. As we have alreay note, investment per worker i equals sy. By substituting the prouction function for y, we can express investment per worker as a function of the capital stock per worker: i = sf(k). This equation relates the existing stock of capital k to the accumulation of new capital i. Figure 7-2 shows this relationship. This figure illustrates how, for any value of k, the amount of output is etermine by the prouction function f(k), FIGURE 7-2 Output per worker, y Output per worker Output, f(k) Output, Consumption, an Investment The saving rate s etermines the allocation of output between consumption an investment. For any level of capital k, output is f(k), investment is sf(k), an consumption is f(k) sf(k). y c Consumption per worker Investment, sf(k) i Investment per worker Capital per worker, k

6 196 PART III Growth Theory: The Economy in the Very Long Run an the allocation of that output between consumption an saving is etermine by the saving rate s. To incorporate epreciation into the moel, we assume that a certain fraction of the capital stock wears out each year. Here (the lowercase Greek letter elta) is calle the epreciation rate. For example, if capital lasts an average of 25 years, then the epreciation rate is 4 percent per year ( = 0.04). The amount of capital that epreciates each year is k. Figure 7-3 shows how the amount of epreciation epens on the capital stock. We can express the impact of investment an epreciation on the capital stock with this equation: Change in Capital Stock = Investment Depreciation D k = i k, where k is the change in the capital stock between one year an the next. Because Dinvestment i equals sf(k), we can write this as D k = sf(k) k. Figure 7-4 graphs the terms of this equation investment an epreciation for ifferent levels of the capital stock k. The higher the capital stock, the greater the amounts of output an investment. Yet the higher the capital stock, the greater also the amount of epreciation. As Figure 7-4 shows, there is a single capital stock k* at which the amount of investment equals the amount of epreciation. If the economy fins itself at this level of the capital stock, the capital stock will not change because the two forces acting on it investment an epreciation just balance. That is, at k*, D k = 0, so the capital stock k an output f(k) are steay over time (rather than growing or shrinking). We therefore call k* the steay-state level of capital. The steay state is significant for two reasons. As we have just seen, an economy at the steay state will stay there. In aition, an just as important, FIGURE 7-3 Depreciation per worker, k Depreciation, k Depreciation A constant fraction of the capital stock wears out every year. Depreciation is therefore proportional to the capital stock. Capital per worker, k

7 CHAPTER 7 Economic Growth I: Capital Accumulation an Population Growth 197 FIGURE 7-4 Investment an epreciation k 2 i 2 i* k* i 1 k 1 Depreciation, k Investment, sf(k) Investment, Depreciation, an the Steay State The steay-state level of capital k* is the level at which investment equals epreciation, inicating that the amount of capital will not change over time. Below k* investment excees epreciation, so the capital stock grows. Above k* investment is less than epreciation, so the capital stock shrinks. Capital stock increases because investment excees epreciation. k 1 k* k 2 Capital per worker, k Steay-state level of capital per worker Capital stock ecreases because epreciation excees investment. an economy not at the steay state will go there. That is, regarless of the level of capital with which the economy begins, it ens up with the steay-state level of capital. In this sense, the steay state represents the long-run equilibrium of the economy. To see why an economy always ens up at the steay state, suppose that the economy starts with less than the steay-state level of capital, such as level k 1 in Figure 7-4. In this case, the level of investment excees the amount of epreciation. Over time, the capital stock will rise an will continue to rise along with output f(k) until it approaches the steay state k*. Similarly, suppose that the economy starts with more than the steay-state level of capital, such as level k 2. In this case, investment is less than epreciation: capital is wearing out faster than it is being replace. The capital stock will fall, again approaching the steay-state level. Once the capital stock reaches the steay state, investment equals epreciation, an there is no pressure for the capital stock to either increase or ecrease. Approaching the Steay State: A Numerical Example Let s use a numerical example to see how the Solow moel works an how the economy approaches the steay state. For this example, we assume that the prouction function is Y = K 1/2 L 1/2. From Chapter 3, you will recognize this as the Cobb Douglas prouction function with the capital-share parameter equal to 1/2. To erive the per-worker a

8 198 PART III Growth Theory: The Economy in the Very Long Run prouction function f(k), ivie both sies of the prouction function by the labor force L: Y K = 1/2 L 1/2. L L Rearrange to obtain Y L K L = ( ) 1/2. Because y = Y/L an k = K/L, this equation becomes y = k 1/2, which can also be written as y = k. This form of the prouction function states that output per worker equals the square root of the amount of capital per worker. To complete the example, let s assume that 30 percent of output is save (s = 0.3), that 10 percent of the capital stock epreciates every year ( = 0.1), an that the economy starts off with 4 units of capital per worker (k = 4). Given these numbers, we can now examine what happens to this economy over time. We begin by looking at the prouction an allocation of output in the first year, when the economy has 4 units of capital per worker. Here are the steps we follow. Accoring to the prouction function y = k, the 4 units of capital per worker (k) prouce 2 units of output per worker (y). Because 30 percent of output is save an investe an 70 percent is consume, i = 0.6 an c = 1.4. Because 10 percent of the capital stock epreciates, k = 0.4. With investment of 0.6 an epreciation of 0.4, the change in the capital stock is D k = 0.2. Thus, the economy begins its secon year with 4.2 units of capital per worker. We can o the same calculations for each subsequent year. Table 7-2 shows how the economy progresses. Every year, because investment excees epreciation, new capital is ae an output grows. Over many years, the economy approaches a steay state with 9 units of capital per worker. In this steay state, investment of 0.9 exactly offsets epreciation of 0.9, so the capital stock an output are no longer growing. Following the progress of the economy for many years is one way to fin the steay-state capital stock, but there is another way that requires fewer calculations. Recall that D k = sf(k) k. This equation shows how k evolves over time. Because the steay state is (by efinition) the value of k at which k = 0, we know that D 0 = sf(k*) k*,

9 CHAPTER 7 Economic Growth I: Capital Accumulation an Population Growth 199 TABLE 7-2 Approaching the Steay State: A Numerical Example Assumptions: y = k ; s = 0.3; = 0.1; initial k = 4.0 Year k y c i k D k or, equivalently, k* f(k*) s =. This equation provies a way of fining the steay-state level of capital per worker, k*. Substituting in the numbers an prouction function from our example, we obtain k* 0.3 =. k * 0.1 Now square both sies of this equation to fin k* = 9. The steay-state capital stock is 9 units per worker. This result confirms the calculation of the steay state in Table 7-2.

10 200 PART III Growth Theory: The Economy in the Very Long Run CASE STUDY The Miracle of Japanese an German Growth Japan an Germany are two success stories of economic growth. Although toay they are economic superpowers, in 1945 the economies of both countries were in shambles. Worl War II ha estroye much of their capital stocks. In the ecaes after the war, however, these two countries experience some of the most rapi growth rates on recor. Between 1948 an 1972, output per person grew at 8.2 percent per year in Japan an 5.7 percent per year in Germany, compare to only 2.2 percent per year in the Unite States. Are the postwar experiences of Japan an Germany so surprising from the stanpoint of the Solow growth moel? Consier an economy in steay state. Now suppose that a war estroys some of the capital stock. (That is, suppose the capital stock rops from k* to k 1 in Figure 7-4.) Not surprisingly, the level of output falls immeiately. But if the saving rate the fraction of output evote to saving an investment is unchange, the economy will then experience a perio of high growth. Output grows because, at the lower capital stock, more capital is ae by investment than is remove by epreciation. This high growth continues until the economy approaches its former steay state. Hence, although estroying part of the capital stock immeiately reuces output, it is followe by higher-than-normal growth. The miracle of rapi growth in Japan an Germany, as it is often escribe in the business press, is what the Solow moel preicts for countries in which war has greatly reuce the capital stock. How Saving Affects Growth The explanation of Japanese an German growth after Worl War II is not quite as simple as suggeste in the preceing case stuy. Another relevant fact is that both Japan an Germany save an invest a higher fraction of their output than oes the Unite States. To unerstan more fully the international ifferences in economic performance, we must consier the effects of ifferent saving rates. Consier what happens to an economy when its saving rate increases. Figure 7-5 shows such a change. The economy is assume to begin in a steay state with saving rate s 1 an capital stock k* 1. When the saving rate increases from s 1 to s 2, the sf(k) curve shifts upwar. At the initial saving rate s 1 an the initial capital stock k* 1, the amount of investment just offsets the amount of epreciation. Immeiately after the saving rate rises, investment is higher, but the capital stock an epreciation are unchange. Therefore, investment excees epreciation. The capital stock will graually rise until the economy reaches the new steay state k* 2, which has a higher capital stock an a higher level of output than the ol steay state. The Solow moel shows that the saving rate is a key eterminant of the steay-state capital stock. If the saving rate is high, the economy will have a large capital stock an a high level of output in the steay state. If the saving rate is low, the econ-

11 CHAPTER 7 Economic Growth I: Capital Accumulation an Population Growth 201 FIGURE 7-5 Investment an epreciation k s 2 f(k) s 1 f(k) causing the capital stock to grow towar a new steay state. 1. An increase in the saving rate raises investment,... k* 1 An Increase in the Saving Rate An increase in the saving rate s implies that the amount of investment for any given capital stock is higher. It therefore shifts the saving function upwar. At the initial steay state k 1 *, investment now excees epreciation. The capital stock rises until the economy reaches a new steay state k 2 * with more capital an output. k* 2 Capital per worker, k omy will have a small capital stock an a low level of output in the steay state. This conclusion shes light on many iscussions of fiscal policy. As we saw in Chapter 3, a government buget eficit can reuce national saving an crow out investment. Now we can see that the long-run consequences of a reuce saving rate are a lower capital stock an lower national income. This is why many economists are critical of persistent buget eficits. What oes the Solow moel say about the relationship between saving an economic growth? Higher saving leas to faster growth in the Solow moel, but only temporarily. An increase in the rate of saving raises growth only until the economy reaches the new steay state. If the economy maintains a high saving rate, it will maintain a large capital stock an a high level of output, but it will not maintain a high rate of growth forever. Policies that alter the steay-state growth rate of income per person are sai to have a growth effect; we will see examples of such policies in the next chapter. By contrast, a higher saving rate is sai to have a level effect, because only the level of income per person not its growth rate is influence by the saving rate in the steay state. Now that we unerstan how saving an growth interact, we can more fully explain the impressive economic performance of Germany an Japan after Worl War II. Not only were their initial capital stocks low because of the war, but their steay-state capital stocks were also high because of their high saving rates. Both of these facts help explain the rapi growth of these two countries in the 1950s an 1960s.

12 202 PART III Growth Theory: The Economy in the Very Long Run CASE STUDY Saving an Investment Aroun the Worl We starte this chapter with an important question: Why are some countries so rich while others are mire in poverty? Our analysis has taken us a step closer to the answer. Accoring to the Solow moel, if a nation evotes a large fraction of its income to saving an investment, it will have a high steay-state capital stock an a high level of income. If a nation saves an invests only a small fraction of its income, its steay-state capital an income will be low. Let s now look at some ata to see if this theoretical result in fact helps explain the large international variation in stanars of living. Figure 7-6 is a scatterplot of ata from 96 countries. (The figure inclues most of the worl s economies. It exclues major oil-proucing countries an countries that were communist uring much of this perio, because their experiences are explaine by their spe- FIGURE 7-6 Income per person in 2003 (logarithmic scale) 100,000 10,000 1,000 Rwana Ethiopia Barbaos Cameroon El Salvaor Inia Nigeria Buruni Unite States Unite Kingom Argentina South Africa Togo Ghana Pakistan Guinea-Bissau Luxembourg Spain Greece Mexico Peru Ecuaor Switzerlan China Norway Japan Finlan South Korea Republic of Congo Thailan Zambia Investment as percentage of output (average ) International Evience on Investment Rates an Income per Person This scatterplot shows the experience of 96 countries, each represente by a single point. The horizontal axis shows the country s rate of investment, an the vertical axis shows the country s income per person. High investment is associate with high income per person, as the Solow moel preicts. Source: Alan Heston, Robert Summers, an Bettina Aten, Penn Worl Table Version 6.2, Center for International Comparisons of Prouction, Income an Prices at the University of Pennsylvania, September 2006.

13 CHAPTER 7 Economic Growth I: Capital Accumulation an Population Growth 203 cial circumstances.) The ata show a positive relationship between the fraction of output evote to investment an the level of income per person. That is, countries with high rates of investment, such as the Unite States an Japan, usually have high incomes, whereas countries with low rates of investment, such as Ethiopia an Buruni, have low incomes. Thus, the ata are consistent with the Solow moel s preiction that the investment rate is a key eterminant of whether a country is rich or poor. The strong correlation shown in this figure is an important fact, but it raises as many questions as it resolves. One might naturally ask, why o rates of saving an investment vary so much from country to country? There are many potential answers, such as tax policy, retirement patterns, the evelopment of financial markets, an cultural ifferences. In aition, political stability may play a role: not surprisingly, rates of saving an investment ten to be low in countries with frequent wars, revolutions, an coups. Saving an investment also ten to be low in countries with poor political institutions, as measure by estimates of official corruption. A final interpretation of the evience in Figure 7-6 is reverse causation: perhaps high levels of income somehow foster high rates of saving an investment. Unfortunately, there is no consensus among economists about which of the many possible explanations is most important. The association between investment rates an income per person is strong, an it is an important clue to why some countries are rich an others poor, but it is not the whole story. The correlation between these two variables is far from perfect. The Unite States an Peru, for instance, have ha similar investment rates, but income per person is more than eight times higher in the Unite States. There must be other eterminants of living stanars beyon saving an investment. Later in this chapter an also in the next one, we return to the international ifferences in income per person to see what other variables enter the picture. 7-2 The Golen Rule Level of Capital So far, we have use the Solow moel to examine how an economy s rate of saving an investment etermines its steay-state levels of capital an income. This analysis might lea you to think that higher saving is always a goo thing because it always leas to greater income. Yet suppose a nation ha a saving rate of 100 percent. That woul lea to the largest possible capital stock an the largest possible income. But if all of this income is save an none is ever consume, what goo is it? This section uses the Solow moel to iscuss the optimal amount of capital accumulation from the stanpoint of economic well-being. In the next chapter, we iscuss how government policies influence a nation s saving rate. But first, in this section, we present the theory behin these policy ecisions.

14 204 PART III Growth Theory: The Economy in the Very Long Run Comparing Steay States To keep our analysis simple, let s assume that a policymaker can set the economy s saving rate at any level. By setting the saving rate, the policymaker etermines the economy s steay state. What steay state shoul the policymaker choose? The policymaker s goal is to maximize the well-being of the iniviuals who make up the society. Iniviuals themselves o not care about the amount of capital in the economy, or even the amount of output. They care about the amount of goos an services they can consume. Thus, a benevolent policymaker woul want to choose the steay state with the highest level of consumption. The steay-state value of k that maximizes consumption is calle the Golen Rule level of capital an is enote k* gol. 2 How can we tell whether an economy is at the Golen Rule level? To answer this question, we must first etermine steay-state consumption per worker. Then we can see which steay state provies the most consumption. To fin steay-state consumption per worker, we begin with the national income accounts ientity an rearrange it as y = c + i c = y i. Consumption is output minus investment. Because we want to fin steay-state consumption, we substitute steay-state values for output an investment. Steay-state output per worker is f(k*), where k* is the steay-state capital stock per worker. Furthermore, because the capital stock is not changing in the steay state, investment equals epreciation k*. Substituting f(k*) for y an k* for i, we can write steay-state consumption per worker as c* = f(k*) k*. Accoring to this equation, steay-state consumption is what s left of steay-state output after paying for steay-state epreciation. This equation shows that an increase in steay-state capital has two opposing effects on steay-state consumption. On the one han, more capital means more output. On the other han, more capital also means that more output must be use to replace capital that is wearing out. Figure 7-7 graphs steay-state output an steay-state epreciation as a function of the steay-state capital stock. Steay-state consumption is the gap between output an epreciation. This figure shows that there is one level of the capital stock the Golen Rule level k* gol that maximizes consumption. When comparing steay states, we must keep in min that higher levels of capital affect both output an epreciation. If the capital stock is below the 2 Emun Phelps, The Golen Rule of Accumulation: A Fable for Growthmen, American Economic Review 51 (September 1961):

15 CHAPTER 7 Economic Growth I: Capital Accumulation an Population Growth 205 FIGURE 7-7 Steay-state output an epreciation k* gol Below the Golen Rule steay state, increases in steay-state capital raise steay-state consumption. c* gol Above the Golen Rule steay state, increases in steay-state capital reuce steay-state consumption. Steay-state epreciation (an investment), k* Steay-state output, f(k*) Steay-state capital per worker, k* Steay-State Consumption The economy s output is use for consumption or investment. In the steay state, investment equals epreciation. Therefore, steay-state consumption is the ifference between output f( k*) an epreciation k*. Steay-state consumption is maximize at the Golen Rule steay state. The Golen Rule capital stock is enote k* gol, an the Golen Rule level of consumption is enote c* gol. Golen Rule level, an increase in the capital stock raises output more than epreciation, so consumption rises. In this case, the prouction function is steeper than the k* line, so the gap between these two curves which equals consumption grows as k* rises. By contrast, if the capital stock is above the Golen Rule level, an increase in the capital stock reuces consumption, because the increase in output is smaller than the increase in epreciation. In this case, the prouction function is flatter than the k* line, so the gap between the curves consumption shrinks as k* rises. At the Golen Rule level of capital, the prouction function an the k* line have the same slope, an consumption is at its greatest level. We can now erive a simple conition that characterizes the Golen Rule level of capital. Recall that the slope of the prouction function is the marginal prouct of capital MPK. The slope of the k* line is. Because these two slopes are equal at k* gol, the Golen Rule is escribe by the equation MPK =. At the Golen Rule level of capital, the marginal prouct of capital equals the epreciation rate. To make the point somewhat ifferently, suppose that the economy starts at some steay-state capital stock k* an that the policymaker is consiering increasing the capital stock to k* + 1. The amount of extra output from this increase in capital woul be f(k* + 1) f(k*), the marginal prouct of capital MPK. The amount of extra epreciation from having 1 more unit of capital is

16 206 PART III Growth Theory: The Economy in the Very Long Run the epreciation rate. Thus, the net effect of this extra unit of capital on consumption is MPK. If MPK > 0, then increases in capital increase con- sumption, so k* must be below the Golen Rule level. If MPK < 0, then increases in capital ecrease consumption, so k* must be above the Golen Rule level. Therefore, the following conition escribes the Golen Rule: MPK = 0. At the Golen Rule level of capital, the marginal prouct of capital net of epreciation (MPK ) equals zero. As we will see, a policymaker can use this conition to fin the Golen Rule capital stock for an economy. 3 Keep in min that the economy oes not automatically gravitate towar the Golen Rule steay state. If we want any particular steay-state capital stock, such as the Golen Rule, we nee a particular saving rate to support it. Figure 7-8 shows the steay state if the saving rate is set to prouce the Golen Rule level of capital. If the saving rate is higher than the one use in this figure, the FIGURE 7-8 Steay-state output, epreciation, an investment per worker k* f(k*) c* gol s gol f(k*) i* gol k* gol Steay-state capital per worker, k* 1. To reach the Golen Rule steay state the economy nees the right saving rate. The Saving Rate an the Golen Rule There is only one saving rate that prouces the Golen Rule level of capital k* gol. Any change in the saving rate woul shift the sf(k) curve an woul move the economy to a steay state with a lower level of consumption. 3 Mathematical note: Another way to erive the conition for the Golen Rule uses a bit of calculus. Recall that c* = f(k*) k*. To fin the k* that maximizes c*, ifferentiate to fin c*/k* = f (k*) an set this erivative equal to zero. Noting that f (k*) is the marginal prouct of capital, we obtain the Golen Rule conition in the text.

17 CHAPTER 7 Economic Growth I: Capital Accumulation an Population Growth 207 steay-state capital stock will be too high. If the saving rate is lower, the steaystate capital stock will be too low. In either case, steay-state consumption will be lower than it is at the Golen Rule steay state. Fining the Golen Rule Steay State: A Numerical Example Consier the ecision of a policymaker choosing a steay state in the following economy. The prouction function is the same as in our earlier example: y = k. Output per worker is the square root of capital per worker. Depreciation is again 10 percent of capital. This time, the policymaker chooses the saving rate s an thus the economy s steay state. To see the outcomes available to the policymaker, recall that the following equation hols in the steay state: k* = s. f(k*) In this economy, this equation becomes k* s =. k* 0.1 Squaring both sies of this equation yiels a solution for the steay-state capital stock. We fin k* = 100s 2. Using this result, we can compute the steay-state capital stock for any saving rate. Table 7-3 presents calculations showing the steay states that result from various saving rates in this economy. We see that higher saving leas to a higher capital stock, which in turn leas to higher output an higher epreciation. Steay-state consumption, the ifference between output an epreciation, first rises with higher saving rates an then eclines. Consumption is highest when the saving rate is 0.5. Hence, a saving rate of 0.5 prouces the Golen Rule steay state. Recall that another way to ientify the Golen Rule steay state is to fin the capital stock at which the net marginal prouct of capital (MPK ) equals zero. For this prouction function, the marginal prouct is 4 1 MPK =. 2 k 4 Mathematical note: To erive this formula, note that the marginal prouct of capital is the erivative of the prouction function with respect to k.

18 208 PART III Growth Theory: The Economy in the Very Long Run TABLE 7-3 Fining the Golen Rule Steay State: A Numerical Example Assumptions: y = k ; = 0.1 s k* y* k* c* MPK MPK Using this formula, the last two columns of Table 7-3 present the values of MPK an MPK in the ifferent steay states. Note that the net marginal prouct of capital is exactly zero when the saving rate is at its Golen Rule value of 0.5. Because of iminishing marginal prouct, the net marginal prouct of capital is greater than zero whenever the economy saves less than this amount, an it is less than zero whenever the economy saves more. This numerical example confirms that the two ways of fining the Golen Rule steay state looking at steay-state consumption or looking at the marginal prouct of capital give the same answer. If we want to know whether an actual economy is currently at, above, or below its Golen Rule capital stock, the secon metho is usually more convenient, because it is relatively straightforwar to estimate the marginal prouct of capital. By contrast, evaluating an economy with the first metho requires estimates of steay-state consumption at many ifferent saving rates; such information is harer to obtain. Thus, when we apply this kin of analysis to the U.S. economy in the next chapter, we will evaluate U.S. saving by examining the marginal prouct of capital. Before engaging in that policy analysis, however, we nee to procee further in our evelopment an unerstaning of the Solow moel. The Transition to the Golen Rule Steay State Let s now make our policymaker s problem more realistic. So far, we have been assuming that the policymaker can simply choose the economy s steay state an jump there immeiately. In this case, the policymaker woul choose the steay state with highest consumption the Golen Rule steay state. But now suppose that the economy has reache a steay state other than the Golen Rule. What

19 CHAPTER 7 Economic Growth I: Capital Accumulation an Population Growth 209 happens to consumption, investment, an capital when the economy makes the transition between steay states? Might the impact of the transition eter the policymaker from trying to achieve the Golen Rule? We must consier two cases: the economy might begin with more capital than in the Golen Rule steay state, or with less. It turns out that the two cases offer very ifferent problems for policymakers. (As we will see in the next chapter, the secon case too little capital escribes most actual economies, incluing that of the Unite States.) Starting With Too Much Capital We first consier the case in which the economy begins at a steay state with more capital than it woul have in the Golen Rule steay state. In this case, the policymaker shoul pursue policies aime at reucing the rate of saving in orer to reuce the capital stock. Suppose that these policies succee an that at some point call it time t 0 the saving rate falls to the level that will eventually lea to the Golen Rule steay state. Figure 7-9 shows what happens to output, consumption, an investment when the saving rate falls. The reuction in the saving rate causes an immeiate increase in consumption an a ecrease in investment. Because investment an epreciation were equal in the initial steay state, investment will now be less than epreciation, which means the economy is no longer in a steay state. Graually, the capital stock falls, leaing to reuctions in output, consumption, an investment. These variables continue to fall until the economy reaches the new steay state. Because we are assuming that the new steay state is the Golen Rule steay state, consumption must be higher than it was before the change in the saving rate, even though output an investment are lower. FIGURE 7-9 Output, y Consumption, c Investment, i Reucing Saving When Starting With More Capital Than in the Golen Rule Steay State This figure shows what happens over time to output, consumption, an investment when the economy begins with more capital than the Golen Rule level an the saving rate is reuce. The reuction in the saving rate (at time t 0 ) causes an immeiate increase in consumption an an equal ecrease in investment. Over time, as the capital stock falls, output, consumption, an investment fall together. Because the economy began with too much capital, the new steay state has a higher level of consumption than the initial steay state. t 0 Time The saving rate is reuce.

20 210 PART III Growth Theory: The Economy in the Very Long Run Note that, compare to the ol steay state, consumption is higher not only in the new steay state but also along the entire path to it. When the capital stock excees the Golen Rule level, reucing saving is clearly a goo policy, for it increases consumption at every point in time. Starting With Too Little Capital When the economy begins with less capital than in the Golen Rule steay state, the policymaker must raise the saving rate to reach the Golen Rule. Figure 7-10 shows what happens. The increase in the saving rate at time t 0 causes an immeiate fall in consumption an a rise in investment. Over time, higher investment causes the capital stock to rise. As capital accumulates, output, consumption, an investment graually increase, eventually approaching the new steay-state levels. Because the initial steay state was below the Golen Rule, the increase in saving eventually leas to a higher level of consumption than that which prevaile initially. Does the increase in saving that leas to the Golen Rule steay state raise economic welfare? Eventually it oes, because the new steay-state level of consumption is higher than the initial level. But achieving that new steay state requires an initial perio of reuce consumption. Note the contrast to the case in which the economy begins above the Golen Rule. When the economy begins above the Golen Rule, reaching the Golen Rule prouces higher consumption at all points in time. When the economy begins below the Golen Rule, reaching the Golen Rule requires initially reucing consumption to increase consumption in the future. When eciing whether to try to reach the Golen Rule steay state, policymakers have to take into account that current consumers an future consumers are not always the same people. Reaching the Golen Rule achieves the highest steay-state level of consumption an thus benefits future generations. But when FIGURE 7-10 Output, y Consumption, c Investment, i t 0 Time Increasing Saving When Starting With Less Capital Than in the Golen Rule Steay State This figure shows what happens over time to output, consumption, an investment when the economy begins with less capital than the Golen Rule level an the saving rate is increase. The increase in the saving rate (at time t 0 ) causes an immeiate rop in consumption an an equal jump in investment. Over time, as the capital stock grows, output, consumption, an investment increase together. Because the economy began with less capital than the Golen Rule level, the new steay state has a higher level of consumption than the initial steay state. The saving rate is increase.

21 CHAPTER 7 Economic Growth I: Capital Accumulation an Population Growth 211 the economy is initially below the Golen Rule, reaching the Golen Rule requires raising investment an thus lowering the consumption of current generations. Thus, when choosing whether to increase capital accumulation, the policymaker faces a traeoff among the welfare of ifferent generations. A policymaker who cares more about current generations than about future ones may ecie not to pursue policies to reach the Golen Rule steay state. By contrast, a policymaker who cares about all generations equally will choose to reach the Golen Rule. Even though current generations will consume less, an infinite number of future generations will benefit by moving to the Golen Rule. Thus, optimal capital accumulation epens crucially on how we weigh the interests of current an future generations. The biblical Golen Rule tells us, o unto others as you woul have them o unto you. If we hee this avice, we give all generations equal weight. In this case, it is optimal to reach the Golen Rule level of capital which is why it is calle the Golen Rule. 7-3 Population Growth The basic Solow moel shows that capital accumulation, by itself, cannot explain sustaine economic growth: high rates of saving lea to high growth temporarily, but the economy eventually approaches a steay state in which capital an output are constant. To explain the sustaine economic growth that we observe in most parts of the worl, we must expan the Solow moel to incorporate the other two sources of economic growth population growth an technological progress. In this section we a population growth to the moel. Instea of assuming that the population is fixe, as we i in Sections 7-1 an 7-2, we now suppose that the population an the labor force grow at a constant rate n. For example, the U.S. population grows about 1 percent per year, so n = This means that if 150 million people are working one year, then million ( ) are working the next year, an million ( ) the year after that, an so on. The Steay State With Population Growth How oes population growth affect the steay state? To answer this question, we must iscuss how population growth, along with investment an epreciation, influences the accumulation of capital per worker. As we note before, investment raises the capital stock, an epreciation reuces it. But now there is a thir force acting to change the amount of capital per worker: the growth in the number of workers causes capital per worker to fall. We continue to let lowercase letters stan for quantities per worker. Thus, k = K/L is capital per worker, an y = Y/L is output per worker. Keep in min, however, that the number of workers is growing over time. The change in the capital stock per worker is D k = i ( + n)k.

22 212 PART III Growth Theory: The Economy in the Very Long Run This equation shows how investment, epreciation, an population growth influence the per-worker capital stock. Investment increases k, whereas epreciation an population growth ecrease k. We saw this equation earlier in this chapter for the special case of a constant population (n = 0). We can think of the term ( + n)k as efining break-even investment the amount of investment necessary to keep the capital stock per worker constant. Break-even investment inclues the epreciation of existing capital, which equals k. It also inclues the amount of investment necessary to provie new workers with capital. The amount of investment necessary for this purpose is nk, because there are n new workers for each existing worker an because k is the amount of capital for each worker. The equation shows that population growth reuces the accumulation of capital per worker much the way epreciation oes. Depreciation reuces k by wearing out the capital stock, whereas population growth reuces k by spreaing the capital stock more thinly among a larger population of workers. 5 Our analysis with population growth now procees much as it i previously. First, we substitute sf(k) for i. The equation can then be written as D k = sf(k) ( + n)k. To see what etermines the steay-state level of capital per worker, we use Figure 7-11, which extens the analysis of Figure 7-4 to inclue the effects of pop- FIGURE 7-11 Investment, break-even investment Break-even investment, ( + n)k Investment, sf(k) k* Capital per worker, k The steay state Population Growth in the Solow Moel Depreciation an population growth are two reasons the capital stock per worker shrinks. If n is the rate of population growth an is the rate of epreciation, then ( + n)k is break-even investment the amount of investment necessary to keep constant the capital stock per worker k. For the economy to be in a steay state, investment sf(k) must offset the effects of epreciation an population growth ( + n)k. This is represente by the crossing of the two curves. 5 Mathematical note: Formally eriving the equation for the change in k requires a bit of calculus. Note that the change in k per unit of time is k/t = (K/L)/t. After applying the stanar rules of calculus, we can write this as k/t = (1/L)(K/t) (K/L 2 )(L/t). Now use the following facts to substitute in this equation: K/t = I K an (L/t)/L = n. After a bit of manipulation, this prouces the equation in the text.

23 CHAPTER 7 Economic Growth I: Capital Accumulation an Population Growth 213 ulation growth. An economy is in a steay state if capital per worker k is unchanging. As before, we esignate the steay-state value of k as k*. If k is less than k*, investment is greater than break-even investment, so k rises. If k is greater than k*, investment is less than break-even investment, so k falls. In the steay state, the positive effect of investment on the capital stock per worker exactly balances the negative effects of epreciation an population growth. That is, at k*, D k = 0 an i* = k* + nk*. Once the economy is in the steay state, investment has two purposes. Some of it ( k*) replaces the epreciate capital, an the rest (nk*) provies the new workers with the steay-state amount of capital. The Effects of Population Growth Population growth alters the basic Solow moel in three ways. First, it brings us closer to explaining sustaine economic growth. In the steay state with population growth, capital per worker an output per worker are constant. Because the number of workers is growing at rate n, however, total capital an total output must also be growing at rate n. Hence, although population growth cannot explain sustaine growth in the stanar of living (because output per worker is constant in the steay state), it can help explain sustaine growth in total output. Secon, population growth gives us another explanation for why some countries are rich an others are poor. Consier the effects of an increase in population growth. Figure 7-12 shows that an increase in the rate of population FIGURE 7-12 Investment, break-even investment 1. An increase in the rate of population growth... ( + n 2 )k ( + n 1 )k sf(k) The Impact of Population Growth An increase in the rate of population growth from n 1 to n 2 shifts the line representing population growth an epreciation upwar. The new steay state k 2 * has a lower level of capital per worker than the initial steay state k 1 *. Thus, the Solow moel preicts that economies with higher rates of population growth will have lower levels of capital per worker an therefore lower incomes. k* 2 k* 1 Capital per worker, k reuces the steaystate capital stock.