Advanced Topics in Macroeconomics

Divya
Divya Tuteja
Tuteja
Lecture
Lecture Notes, IIFT
Notes, IIFT

MAEco
MA Eco(2022-24)
(2019-21)
April, 2020
May, 2022
 Endogenous Growth Models

Tuteja (Lecture Notes, IIFT) ATME MA Eco (2022-24)

 Session Objectives
• One-sector Model

• Lucas-Uzawa Model

Tuteja (Lecture Notes, IIFT) ATME MA Eco (2022-24)

 One-Sector Model
• Neoclassical Growth Theory

• Endogenous Growth theory

• Institutions-based Theories of Growth

• Let us discuss the key features of each of the

theories

Tuteja (Lecture Notes, IIFT) ATME MA Eco (2022-24)

 Neoclassical Growth Theory
• Neoclassical Growth Theory (Solow; RCK)
Features
• Long Run (steady state) growth is explained by
exogenous population growth and exogenous
technological progress.
• Growth during transition (away from steady state) is
explained by factor accumulation.
• Predicts convergence: poor economies will eventually
catch up with the rich ones
• There is no scope for government intervention (since we
have perfect markets and rational expectations)
• There is no attempt to explain technological progress

Tuteja (Lecture Notes, IIFT) ATME MA Eco (2022-24)

 Endogenous Growth Theory
• Endogenous Growth Theory (Romer; Barro;
Lucas; Grossman-Helpman; Aghion-Howitt)
Features
• Attempts to explain technical progress and productivity
growth in terms of
• Direct R&D activities by firms (Romer, Aghion-Howitt);
• Government investment in infrastructure (Barro);
• International trade and concomitant technology transfer
(Grossman-Helpman);
• Education and skill Formation by households (Lucas; Nelson-
Phelps)
• No separate transitional dynamics
• Does not predict convergence
• In several cases, may argue for active government
intervention

Tuteja (Lecture Notes, IIFT) ATME MA Eco (2022-24)

 Institutions-based Theories of Growth
• Institutions-based Theories of Growth
(Acemoglu; Alesina-Rodrick; Greenwood-
Jovanonvic; Levine)
Features
• These are the most recent works in growth theory which
attempt to link adoption of productive modern
technology to with various kinds of institutions:
• Political economy
• Financial institutions
• Legal framework
• Income distribution and inequality

Tuteja (Lecture Notes, IIFT) ATME MA Eco (2022-24)

 Endogenous Growth Theory

Tuteja (Lecture Notes, IIFT) ATME MA Eco (2022-24)

 Endogenous Growth Theory
• A model will give rise to endogenous growth if it predicts
that the long-run growth rate depends on factors that
may be influenced by the decisions taken up by the
government or the private sector such as levying of taxes
or subsidies, public expenditure or private educational
decisions.

• The literature lays emphasis on two broad aspects that

engender this economic growth
• Capital accumulation by the government or the private agents
• R&D activities by firm

Tuteja (Lecture Notes, IIFT) ATME MA Eco (2022-24)

 Inada Conditions
Role of Inada conditions
• So far, we have assumed that the production technology
satisfies the Inada conditions which facilitated the
construction of phase diagrams.

• However, in a sense these conditions simply imply that

the growth stabilizes to an exogenously given constant
irrespective of the households’ savings plans.

• Further, the steady state capital intensity is constant and

growth was contingent upon the population growth rate
and the rate of technological progress in the economy.

• The Inada conditions do not have an intrinsic appeal in

an intuitive sense!
Tuteja (Lecture Notes, IIFT) ATME MA Eco (2022-24)
 Inada Conditions
• Moreover the Inada conditions are difficult to test
empirically since they deal with the curvature of the
production function for very low and very high levels of
capital.

• Therefore, it seems like a worthwhile effort to abandon at

least some of them. This takes us closer towards the
endogenous growth paradigm.

• The key aspect of traditional growth theory which

ensures that the growth rate declines as more and more
capital is accumulated is the existence of diminishing
returns to capital.

Tuteja (Lecture Notes, IIFT) ATME MA Eco (2022-24)

 Inada Conditions
• Indeed as 𝑘𝑡 increases, 𝐴𝑃𝐾 decreases
𝑑[𝑓(𝑘𝑡 ) 𝑘𝑡 ] 𝑓 𝑘𝑡 −𝑘𝑡 𝑓′ (𝑘𝑡 )
=− <0 (1)
𝑑𝑘𝑡 𝑘𝑡 2
where the term in the square brackets denote the MPL>0.
But the result (1) is not sufficiently strong to ensure the
existence of a constant steady state capital intensity.

• In fact, the existence of a steady state capital-intensity

requires a much stronger result i.e. the equality between
𝑠𝑦𝑡
and (𝛿 + 𝑛) in the Solow model.
𝑘𝑡

• The Inada conditions ensure that this happens.

Tuteja (Lecture Notes, IIFT) ATME MA Eco (2022-24)

 Inada Conditions
• Given 𝐹𝐾 , 𝐹𝐿 > 0; 𝐹𝐾𝐾 , 𝐹𝐿𝐿 < 0; 𝐹𝐾𝐿 > 0 𝑎𝑛𝑑 lim 𝐹𝐾 =
𝐾→0
lim 𝐹𝐿 = ∞ ; lim 𝐹𝐾 = lim 𝐹𝐿 = 0 , we can derive using
𝐿→0 𝐾→∞ 𝐿→∞
L’Hospital’s rule that:
𝑓(𝑘𝑡 ) 𝑓′(𝑘𝑡 )
lim = lim =∞ (2)
𝑘𝑡 →0 𝑘𝑡 𝑘𝑡 →0 1
𝑓(𝑘𝑡 ) 𝑓′(𝑘𝑡 )
lim = lim =0 (3)
𝑘𝑡 →∞ 𝑘𝑡 𝑘𝑡 →∞ 1

𝑠𝑦𝑡
Equations (2) and (3) show that goes to zero (infinity)
𝑘𝑡
as the capital intensity becomes very large (small). This
ensures the existence of a constant steady state capital-
labour ratio and therefore, a balanced growth path.

Tuteja (Lecture Notes, IIFT) ATME MA Eco (2022-24)

 AK Model
• Proposed by Romer (1986); Barro (1990) and Rebelo
(1991) among others.

• In the simplified version, AK model assumes constant

returns to scale (to a broad measure) of capital.
Therefore, the production function for the economy is
described by:
𝑌𝑡 = 𝐴𝐾𝑡 (I)
where A denotes the general productivity.

• Equation I clearly violates the Inada conditions.

Tuteja (Lecture Notes, IIFT) ATME MA Eco (2022-24)

 AK Model
• One could point out that this is obviously unrealistic!
Labour doesn’t even feature in this specification.

• However, there are at least two solid microeconomic

explanations that can be used to justify the existence of
such a macroeconomic production function.

• The explanations hinge upon the existence of

diminishing returns to capital at the firm level along
with existence of external effects which give rise to
constant returns to scale at the macroeconomic level.

• It is assumed that the aggregate population (and also the

labour supply) is constant at 𝐿0 .
Tuteja (Lecture Notes, IIFT) ATME MA Eco (2022-24)
 AK Model
Justification 1:
External Effects between Firms (Saint-Paul, 1992 and
Romer, 1989)

Assumptions:
(i) Large number of identical, perfectly competitive firms.

(ii) The individual firm has no adjustment cost on

investment.

(iii) N0 is the total number of firms which is assumed to be

fixed.

Tuteja (Lecture Notes, IIFT) ATME MA Eco (2022-24)

 AK Model
(iv) The technology available to the representative firm i is
given by:
𝑌𝑖𝑡 = 𝐹 𝐾𝑖𝑡 , 𝐿𝑖𝑡 ≡ 𝐴𝑡 𝐾𝑖𝑡𝛼 𝐿1−𝛼
𝑖𝑡 ; 0 < 𝛼 < 1 (1)
where 𝑌𝑖𝑡 -output; 𝐾𝑖𝑡 -capital input; 𝐿𝑖𝑡 -labour input of
firm i (i=1,…,N0). A represents the general productivity
which is taken as given by each individual firm.

Features of Technology:
(a) Diminishing returns to scale to both factors of
production including capital.
(b) Constant returns to scale to the production factors
jointly.

Tuteja (Lecture Notes, IIFT) ATME MA Eco (2022-24)

 AK Model
• The discounted value of the firm’s cash flows is given by:
∞
𝑉𝑖0 = [𝐹 𝐾𝑖𝑡 , 𝐿𝑖𝑡 − 𝑤𝑡 𝐿𝑖𝑡 − 𝐼𝑖𝑡 ] 𝑒 −𝑅𝑡 𝑑𝑡
0
𝑡
where 𝑅𝑡 ≡ 0 𝑟𝜏 𝑑𝜏 is the cumulative discount factor; 𝐼𝑖𝑡 is
the gross investment by the firm.

• The firm maximizes this subject to the capital

accumulation constraint:
𝐾𝑖𝑡 = 𝐼𝑖𝑡 − 𝛿𝐾𝑖𝑡

We will substitute this into the objective function and

solve.

Tuteja (Lecture Notes, IIFT) ATME MA Eco (2022-24)

 AK Model
• We manipulate the constraint by rewriting it as:
𝐼𝑖𝑡 = 𝐾𝑖𝑡 + 𝑟𝑡 𝐾𝑖𝑡 − 𝑟𝑡 𝐾𝑖𝑡 + 𝛿𝐾𝑖𝑡

Further, we know that

∞ ∞
[𝐾𝑖𝑡 − 𝑟𝑡 𝐾𝑖𝑡 ] 𝑒 −𝑅𝑡 𝑑𝑡 = 𝑑[𝐾𝑖𝑡 𝑒 −𝑅𝑡 ] = −𝐾𝑖 (0− )
0 0

where lim 𝐾𝑖𝑡 𝑒 −𝑅𝑡 = 0 in the final step and 𝐾𝑖 (0− ) is the
𝑡→∞
initial capital stock measured one instant before the firm
makes its decision about 𝐾𝑖𝑡 for 𝑡 ∈ [0, ∞).

Tuteja (Lecture Notes, IIFT) ATME MA Eco (2022-24)

 AK Model
The objective function is now as follows:
∞
𝑉𝑖0 = 𝐾𝑖 0− + [𝐹 𝐾𝑖𝑡 , 𝐿𝑖𝑡 − 𝑤𝑡 𝐿𝑖𝑡 − (𝑟𝑡 + 𝛿)𝐾𝑖𝑡 ] 𝑒 −𝑅𝑡 𝑑𝑡
0
This equation shows that the firm’s decision about decision
about factor inputs is a static one.

Maximization of 𝑉𝑖0 by choice of 𝐿𝑖𝑡 and 𝐾𝑖𝑡 yields the

familiar marginal product conditions for labour and capital:
𝜕𝑌𝑖𝑡
Marginal Product of labour: 𝐹𝐿 𝐾𝑖𝑡 , 𝐿𝑖𝑡 ≡ = 𝑤𝑡
𝜕𝐿𝑖𝑡
𝜕𝑌𝑖𝑡
Marginal Product of capital: 𝐹𝐾 𝐾𝑖𝑡 , 𝐿𝑖𝑡 ≡ = 𝑟𝑡 +𝛿
𝜕𝐾𝑖𝑡
where (𝑟𝑡 + 𝛿) is the rental rate

Tuteja (Lecture Notes, IIFT) ATME MA Eco (2022-24)

 AK Model
𝐾𝑖𝑡
• Further, define 𝑘𝑖𝑡 ≡ as the capital intensity
𝐿𝑖𝑡
𝛼
𝑤𝑡 = (1 − 𝛼)𝐴𝑡 𝑘𝑖𝑡 (2)
and 𝑟𝑡 + 𝛿 = 𝛼𝐴𝑡 𝑘𝑖𝑡𝛼−1 (3)

• Now, the rental rate on the factor is the same for all the
firms and so they will all choose the same capital-intensity
and we will get that for all i=1,…,N0:
𝑘𝑖𝑡 = 𝑘𝑡

Tuteja (Lecture Notes, IIFT) ATME MA Eco (2022-24)

 AK Model
• Now following Saint-Paul (1992) and Romer (1989)
assume that the inter-firm externality takes the following
form:

𝐴𝑡 = 𝑎0 𝐾𝑡1−𝛼 (A)
where 𝑎0 is a positive constant, 𝐾𝑡 = 𝑖 𝐾𝑖𝑡 is the aggregate
capital stock.

• According to this relation, total factor productivity depends

positively on the aggregate capital stock i.e. if an individual
firm i decides to increase its capital stock then all the firms
in the economy will benefit as a result.

Tuteja (Lecture Notes, IIFT) ATME MA Eco (2022-24)

 AK Model
• Using (A), equations 1, 2, and 3 can be rewritten in
aggregate terms as
𝑌𝑡 ≡ 𝑌𝑖𝑡 = 𝐴0 𝐾𝑡
𝑖
where 𝑌𝑡 is the aggregate output and 𝐴0 ≡ 𝑎0 𝐿1−𝛼
0 is a positive
constant.

• All the firms use the same capital intensity so 𝑘𝑖𝑡 = 𝑘𝑡 .

• 𝑌𝑖𝑡 = 𝐿𝑖𝑡 𝐴𝑡 𝑘𝑡𝛼 and 𝑌𝑡 = 𝑖 𝑌𝑖𝑡 = 𝐿0 𝐴𝑡 𝑘𝑡𝛼 , where 𝐿0 ≡ 𝑖 𝐿𝑖𝑡 is
the labour market clearing condition.
• ∵ 𝐾𝑖𝑡 = 𝑘𝑡 𝐿𝑖𝑡 𝐴𝑡 = 𝑎0 𝐿1−𝛼
0 𝑘 1−𝛼
𝑡 and 𝐾𝑡 = 𝑖 𝐾𝑖𝑡 =
𝐾𝑡
𝐿0 𝑘𝑡 𝑜𝑟 𝑘𝑡 = 𝑤𝑡 = 1 − 𝛼 𝐴𝑡 𝑘𝑡𝛼 = 1 − 𝛼 𝑎0 𝐿1−𝛼
0 𝑘𝑡 =
𝐿0
1 − 𝛼 𝑎0 𝐿−𝛼
0 𝐾𝑡 𝑤𝑡 𝐿0 = 1 − 𝛼 𝑌𝑡

Tuteja (Lecture Notes, IIFT) ATME MA Eco (2022-24)

 AK Model
• The rental rate 𝑟𝑡 + 𝛿 = 𝛼𝐴𝑡 𝑘𝑡𝛼−1 = 𝛼𝑎0 𝐿1−𝛼
0 = 𝛼𝐴0 .

• As was asserted above, the national income share of labour

is positive and there are constant returns to scale at the
macroeconomic level.

• Technically, the latter result follows from the fact that the
exponents of 𝐾𝑖 and 𝑘 precisely add up to unity.

Tuteja (Lecture Notes, IIFT) ATME MA Eco (2022-24)

 AK Model
Justification 2:
External Effects between Firms and the Government
(Barro, 1990)

• An alternative version of the AK model was proposed by

Barro (1990). In this version, the stock of public
infrastructure affects the productivity of private firms
and thus impacts the rate of economic growth.

• The technology facing the individual firm is the same as

above.

Tuteja (Lecture Notes, IIFT) ATME MA Eco (2022-24)

 AK Model
The objective function of firm i is given by:
∞
𝑉𝑖0 = [(1 − 𝑡𝑌 )𝐹 𝐾𝑖𝑡 , 𝐿𝑖𝑡 − 𝑤𝑡 𝐿𝑖𝑡 − 𝐼𝑖𝑡 ] 𝑒 −𝑅𝑡 𝑑𝑡
0
where 𝑡𝑌 is a time-invariant output tax ( 0 < 𝑡𝑌 <
1 𝑎𝑛𝑑 𝑡𝑌 = 0).

The capital accumulation equation is given by:

𝐾𝑖𝑡 = 𝐼𝑖𝑡 − 𝛿𝑘 𝐾𝑖𝑡

where 𝛿𝑘 stands for the depreciation rate of private capital.

As before, firm i chooses the optimal path for capital,

employment and investment which maximize 𝑉𝑖0 subject
to the constraint.

Tuteja (Lecture Notes, IIFT) ATME MA Eco (2022-24)

 AK Model
After recalculating, we get the following marginal
productivity conditions for labour and capital:

𝛼
𝑤𝑡 = 1 − 𝑡𝑌 𝐹𝐿 𝐾𝑖𝑡 , 𝐿𝑖𝑡 = (1 − 𝛼) 1 − 𝑡𝑌 𝐴𝑡 𝑘𝑖𝑡

𝛼−1
𝑟𝑡 + 𝛿𝑘 = 1 − 𝑡𝑌 𝐹𝐾 𝐾𝑖𝑡 , 𝐿𝑖𝑡 = 𝛼 1 − 𝑡𝑌 𝐴𝑡 𝑘𝑖𝑡

𝐾𝑖𝑡
where 𝑘𝑖𝑡 ≡ is the capital intensity.
𝐿𝑖𝑡

Tuteja (Lecture Notes, IIFT) ATME MA Eco (2022-24)

 AK Model
Now, in the spirit of Barro, we assume that:
1−𝛼
𝐴𝑡 = 𝑎0 𝐾𝐺𝑡 (B)
where 𝐾𝐺𝑡 is the stock of public capital consisting of
infrastructural objects like roads, airports, bridges and so on.
The key idea is that productive public spending affects all
producers uniformly, these services are free of charge and there
is no congestion effect.

• Using (B), with the other equations we get,

1−𝛼
𝑌𝑡 = 𝐴0 𝐾𝑡𝛼 𝐾𝐺𝑡

𝑤𝑡 𝐿0 = 1 − 𝛼 1 − 𝑡𝑌 𝑌𝑡

1−𝛼
𝐾𝐺𝑡
𝑟𝑡 + 𝛿𝑘 = 𝛼(1 − 𝑡𝑌 )𝐴0
𝐾𝑡
Tuteja (Lecture Notes, IIFT) ATME MA Eco (2022-24)
 AK Model
Several things are worth noting:
1. For a constant stock of public capital, the
macroeconomic production function features
diminishing returns to the private capital stock, 𝐾𝑡
because 𝛼 is less than unity. However, the government
succeeds in maintaining a constant ratio between
public and private stocks of capital, then the model
ends up looking very much like a standard AK model
and thus display endogenous growth. Again what
makes the model tick is the fact that the exponents for
K and for KG precisely add up to unity.
2. Holding constant the ratio between the two types of
capital, the output tax affects the interest rate and thus
the rate of growth in the economy.

Tuteja (Lecture Notes, IIFT) ATME MA Eco (2022-24)

 AK Model
We still need to specify the details of government
behavior. The accumulation identity for the public capital
stock is given by:
𝐾𝐺𝑡 = 𝐼𝐺𝑡 − 𝛿𝑔 𝐾𝐺𝑡
where 𝐼𝐺𝑡 is the flow of public investment, the rate of
which is set by the government and 𝛿𝑔 is the depreciation
rate of public capital.

In the absence of lump-sum taxes, the static government

budget constraint is:
𝑡𝑌 𝑌𝑡 = 𝐼𝐺𝑡 + g𝑌𝑡
where g is the exogenously given national income share of
(useless) government consumption ( g < 𝑡𝑌 ). For given
values of 𝑡𝑌 and g, it follows from the above equation that
the rate of public investment is proportional to output, i.e.
𝐼𝐺𝑡 = (𝑡𝑌 − 𝑔)𝑌𝑡 .
Tuteja (Lecture Notes, IIFT) ATME MA Eco (2022-24)
 HW
• Solve Solow’s model with an AK production technology.

Tuteja (Lecture Notes, IIFT) ATME MA Eco (2022-24)

 Reference
• Heijdra Chapter 14

Tuteja (Lecture Notes, IIFT) ATME MA Eco (2022-24)