Data through the lens of the Solow Model

Persistent growth

Michael McMahon
Department of Economics
Introductory Economics
Outline
1. Recap and first empirical success

2. Growth accounting

3. Convergence

4. Institutions

5. Persistent growth

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1. Recap and first empirical success

3
Recap of the Solow model
o Production function is Cobb-Douglas with
constant returns to scale in capital and labour -
exponent of 1/3 on K
Relationship Equation
o Goods invested for the future determine the Production function ̅ "/$ 𝐿%/$
𝑌! = 𝐴𝐾 ! !
accumulation of capital ̅ !
Capital accumulation ∆𝐾!"# = 𝐼! − 𝑑𝐾
Labour supply 𝐿! = 𝐿'
o The amount of labour in the economy is given
Resource constraint 𝐶! + 𝐼! = 𝑌!
exogenously at a constant level
Allocation of resources 𝐼! = 𝑠𝑌
̅ !

o Output can be consumed or invested

n Agents consume a fraction of output and invest the rest

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 Explaining differences in capital
̅ ∗
̅ ∗ = 𝑑𝐾
o Recall the steady state 𝑠𝑌

o The steady state capital-output

ratio = the ratio of the investment
rate to the depreciation rate
𝐾 ∗ 𝑠̅
=
𝑌 ∗ 𝑑̅
o 𝑑̅ is often assumed constant.

o The model predicts that countries

with high investment rates should
have high capital-output ratio

o This holds up remarkably well.

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2. Growth accounting

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Growth accounting I

o We may often be interested in the drivers of growth.

o That is, how much growth over some period is due to increases in
various factors of production, such as capital and labour.

o Growth accounting helps determine immediate (proximate) sources

of growth and how their contributions change over time.

o Pioneered by Robert Solow and Trevor Svan in 1957.

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* Use the chain rule and the rule for the derivative of the logarithmic function
Aside: useful growth rules
o Suppose two variables 𝑥! and 𝑦! have growth rates of 𝑔" and 𝑔#
o That is, 𝑥!$% = 𝑥! (1 + 𝑔" ) and 𝑦!$% = 𝑦! (1 + 𝑔# )
o Then the following rules apply:*

1. If 𝑧+ = 𝑥+ /𝑦+ , then 𝑔, = 𝑔- − 𝑔.
2. If 𝑧+ = 𝑥+ ×𝑦+ , then 𝑔, = 𝑔- + 𝑔.
3. If 𝑧+ = 𝑥+/ , where 𝛼 is some constant, then 𝑔, = 𝛼×𝑔- .

o Growth rates operations are one level “simpler” than the operations on
original variables, e.g. division becomes subtraction etc.

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*Equalities are exact only in continuous time, but are good approximations in discrete time
Growth accounting II
o Consider the production function, allowing all inputs to depend on time:
%/( )/(
𝑌! = 𝐴! 𝐾! 𝐿!

o 𝐴! is the total factor productivity, or TFP.

o Using the growth rules on the previous slide:

1 2
𝑔*! = 𝑔+! + 𝑔,! + 𝑔-!
3 3
o I.e. Growth rate of GDP =
% )
Growth rate of TFP + × Growth rate of capital + × Growth rate of labour
( (

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Growth accounting in the 20th century
1913-50 Output growth Contribution of Contribution of Contribution of
TFP capital labour
Japan 2.2% 0.7% 1.2% 0.3%
UK 1.3% 0.4% 0.8% 0.1%
US 2.8% 1.3% 0.9% 0.6%
Germany 1.3% 0.3% 0.6% 0.4%

1950-73 Output growth Contribution of Contribution of Contribution of

TFP capital labour
Japan 9.2% 3.6% 3.1% 2.5%
UK 3.0% 1.2% 1.6% 0.2%
US 3.9% 1.6% 1.0% 1.3%
Germany 6.0% 3.3% 2.2% 0.5%

1973-92 Output growth Contribution of Contribution of Contribution of

TFP capital labour
Japan 3.8% 1.0% 2.0% 0.8%
UK 1.6% 0.7% 0.9% 0.0%
US 2.4% 0.2% 0.9% 1.3%
Germany 2.3% 1.5% 0.9% -0.1%

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N. Crafts (2000), Globalization and Growth in the Twentieth Century, IMF WP/00/44
Growth accounting in emerging markets, 1960-1994

Output growth Contribution of Contribution of Contribution of

TFP capital labour
Hong Kong 7.3% 2.4% 2.8% 2.1%
Indonesia 5.6% 0.8% 2.9% 1.9%
Korea 8.3% 1.5% 4.3% 2.5%
Philippines 3.8% -0.4% 2.1% 2.1%
Singapore 8.1% 1.5% 4.4% 2.2%
South Asia 4.2% 0.8% 1.8% 1.6%
Latin America 4.2% 0.2% 1.8% 2.2%
Africa 2.9% -0.6% 1.7% 1.8%
Middle East 4.5% -0.3% 2.5% 2.3%

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N. Crafts (2000), Globalization and Growth in the Twentieth Century, IMF WP/00/44
Growth accounting for the UK 1970-2014
8.0

6.0

4.0
Output growth

2.0

0.0

-2.0

-4.0

-6.0

-8.0
1971
1972
1973
1974
1975
1976
1977
1978
1979
1980
1981
1982
1983
1984
1985
1986
1987
1988
1989
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012
2013
2014
Labour Capital TFP
Average UK growth of 2.1% decomposes into contributions of
0.4% from TFP, 1.2% from capital and 0.5% from labour

12
Office for National Statistics, May 2016
Growth accounting III

o Growth accounting only reveals the immediate contributors to growth.

o It ignores the deeper issue of what causes those changes.

n For example, capital accumulation may itself be driven by higher productivity.

o Yet it has been very useful in studying important economic issues, e.g.:
n Sources of rapid growth of the newly industrializing countries of East Asia.
n Does the US have a productivity slowdown or a measurement problem?
n Importance of misallocation of inputs across firms in developing countries.

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3. Convergence

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Convergence I
o Solow model predicts that if a country is far below its steady state, it
will grow quickly for some time, eventually reaching the steady state

o Therefore, other things equal, “poor” countries (with low output and
capital stock) should grow faster than “rich” ones.

o If true, then the income gap between rich & poor countries would
shrink over time, and living standards “converge.”
 Convergence: Evidence
Starting with a small sample of economies we see convergence (poor countries grow faster
than rich countries)
7

China
Annual Growth 1960-2010

6
South Korea
5
Botswana
4
Ireland
3

2 USA
Switzerland
1

0
0 5000 10000 15000 20000
Level of Development in 1960
Convergence: Evidence
As we add other countries we see that convergence is not the norm but the exception.

China
6
Annual Growth 1960-2010

South Korea
Botswana
5

4
India Ireland
3
Turkey USA
2 Colombia Switzerland
Mexico
1 Philippines
Nigeria Algeria Venezuela
0
0 5000 10000 15000 20000
-1
Level of Development in 1960
Convergence: Evidence
When we include 100+ countries, there is little evidence of convergence.
7
6
Annual Growth 1960-2010

5
4
3
2
1
0
0 5000 10000 15000 20000
-1
-2
GDP per capita in 1960
Convergence II
o Does this mean the Solow model fails?
o No, because “other things” aren’t equal.
o Two implications:
n most countries have already reached their steady states
n most countries are poor not because of bad shocks but because they have
parameters that yield a lower steady state

o What the Solow model really predicts is conditional convergence -

countries converge to their own steady states, which are determined by
their structural characteristics (saving, education, technology etc.)
Differences in steady state output per worker
o The Solow model gives even more weight to TFP in explaining per capita
output than the production model 𝑌 ∗
𝑠̅ ,/.
𝑦∗ ≡ ∗ = 𝐴̅//.
𝐿 𝑑̅
o We can use this formula to understand why some countries are so much richer
o Take the ratio of 𝑦 ∗ for 2 (groups of) countries and assume the 𝑑̅ is the same.
//. ,/.
∗
𝑦0123 𝐴̅0123 𝑠0123
̅
= ×
∗
𝑦4550 𝐴̅4550 𝑠4550
̅
≈64 in the data Must be ≈32 ≈2, since 𝑠$%&'
̅ ≈ 28% and
𝑠())$
̅ ≈ 7% in the data
o TFP differences are crucial for understanding differences in income per capita
across countries.

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Strengths and weaknesses of the Solow model
o Strengths
n It provides a framework to determine how rich a country is in the long run
o long run = steady state, pinned down by technology, investment rate etc.
n The principle of transition dynamics
o can be helpful in understand differences in growth rates across countries
o a country further from the steady state will grow faster
o Weaknesses
n It focusses on investment and capital
o the much more important factor of TFP is left unexplained
n It does not explain differences in investment rates and productivity growth
o Though a more complicated model could endogenise the investment rate
n The model does not provide a theory of sustained long-run growth
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4. Institutions

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Role of Institutions for Economic Development
o Solow model does not explain enormous differences in TFP across countries.
n Highly implausible that they reflect just differences in knowledge and technology.
n Poor countries would need to be using knowledge from more than 100 years ago!

o Frontier of economic growth research: the key is differences in institutions,

which align private and social returns to different activities.
n Socially productive activities: investment, education, R&D etc.
n Socially neutral/harmful activities: receiving bribes, political lobbying, tax evasion etc.
n Good institutions direct people and resources towards socially productive activities.

o Examples of institutions: property rights, rule of law, absence of corruption,

good governance, stability (macroeconomic and political) etc.
Political stability
Transparency
Accountability
Institutions can be measured I
Ease of Doing GDP Per Capita
Country
Business Rank (USD PPP)
Singapore 1 45,978
United Kingdom 4 32,147
United States 5 41,761
Ireland 9 36,278
Japan 18 29,692
Malaysia 21 12,724
Germany 22 32,255
Portugal 31 21,400
Hungary 46 16,896
Poland 70 16,705
Vietnam 78 2,682
China 79 6,200
Russian Federation 123 13,611
Brazil 127 9,455
India 134 2,970
Congo, Dem. Rep. 175 290

Source: Doing Business 2011, World Bank; GDP per capita in 2005 USD (PPP).
Institutions can be measured II

Singapore Brazil

Procedures to start a business 3 16

Days to open a business 3 120
Hours processing forms (yearly) 84 2,600
Taxes as % of profits 28% 70%
Institutions Matter I
GDP per Capita
20000
(1990 $)
18000

16000
South Korea
14000

12000

10000

8000

6000

4000
North Korea
2000

0
1950 1960 1970 1980 1990 2000 2006
Institutions Matter II
The Great Wall: Institutions and income per capita (2007)

Malaysia
Institutional quality

1 USA

Poland UAE
0

Saudi Arabia
-1
Russian Federation
China

-2
800 1600 3200 6400 12800 25600 51200

Oil producing countries Income per capita (2007)

Source: Fatas and Mihov (2009)

5. Persistent growth

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Forecasting 80 Years Ahead: US Real GDP per Capita

11
59900

1. Put yourself in 1928. have been

asked to forecast income per capita in
22000
the year 2009.
10

8100
9

3000
8
1870 1876 1882 1888 1894 1900 1906 1912 1918 1924 1930 1936 1942 1948 1954 1960 1966 1972 1978 1984 1990 1996 2002 2008
Forecasting 80 Years Ahead: US Real GDP per Capita

11
59900
2. You collect data for GDP
per capita from 1970 to
1928.

22000
10

8100
9

3000
8
1870 1876 1882 1888 1894 1900 1906 1912 1918 1924 1930 1936 1942 1948 1954 1960 1966 1972 1978 1984 1990 1996 2002 2008
Forecasting 80 Years Ahead: US Real GDP per Capita

11
59900

22000
10

4. Use the fitted trend to forecast US

income per capita. You find that it
grows by a factor of 4.5 and will reach
8100 $49,773 in 2009
9

3. Fit a trend that

assumes a constant
growth rate
3000
8
1870 1876 1882 1888 1894 1900 1906 1912 1918 1924 1930 1936 1942 1948 1954 1960 1966 1972 1978 1984 1990 1996 2002 2008

Note: the constant-growth-rate trend is a straight line because we use ratio scale. This trend would be exponential if the graph was standard.
Forecasting 80 Years Ahead: US Real GDP per Capita

11
59900

22000
10

5. You predicted $49,773 in 2009 and

the actual number is $46,381, an error
of 7%. Not bad. You deserve a
8100
9 promotion.

3000
8
1870 1876 1882 1888 1894 1900 1906 1912 1918 1924 1930 1936 1942 1948 1954 1960 1966 1972 1978 1984 1990 1996 2002 2008
Persistent growth and the Solow model
o Empirically, economies appear to continue to grow over time
o There is no long-run growth in the Solow model
n Capital accumulation by itself cannot sustain growth due to diminishing returns.
o Can growth in the labour force lead to overall growth?
n It can in the aggregate but not in output per person
n Diminishing returns lead capital per person and output per person to approach steady state
o The principle of transition dynamics:
n If an economy is below steady state then it will grow
n If an economy is above its steady state its growth rate will be negative
n The further below (above) its steady state the faster (slower) an economy will grow
n Helps us understand why economies grow at different rates during certain periods.
o But persistent growth requires persistent technological progress!

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Next lecture

o Modelling ideas as a source of economic growth

n The Romer Model

n Key insight: ideas give us increasing returns to scale,

allowing to sustain growth.

n Reading Ch. 6 of Jones’ textbook before tomorrow’s

lecture will give you a head start J

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