Topic 4:

CHAPTER SEVEN
macro Economic
EconomicGrowth
GrowthI(ch.
(chapter 7)
I 7)

macroeconomics
fifth edition

N. Gregory Mankiw
PowerPoint® Slides
by Ron Cronovich

© 2002 Worth Publishers, all rights reserved

Chapter 7 learning objectives
 Learn the closed economy Solow model
 See how a country’s standard of living
depends on its saving and population
growth rates
 Learn how to use the “Golden Rule”
to find the optimal savings rate and capital
stock

CHAPTER 7 Economic Growth I slide 1

 The importance of
economic growth

…for poor countries

CHAPTER 7 Economic Growth I slide 2

 selected poverty statistics
In the poorest one-fifth of all countries,
 daily caloric intake is 1/3 lower
than in the richest fifth
 the infant mortality rate is
200 per 1000 births, compared to
4 per 1000 births in the richest fifth.

CHAPTER 7 Economic Growth I slide 3

 selected poverty statistics
 In Pakistan, 85% of people live on
less than $2/day
 One-fourth of the poorest countries have
had famines during the past 3 decades.
(none of the richest countries had famines)

 Poverty is associated with the oppression

of women and minorities

CHAPTER 7 Economic Growth I slide 4

Estimated effects of economic growth
 A 10% increase in income is associated with
a 6% decrease in infant mortality
 Income growth also reduces poverty. Example:

Growth and Poverty in Indonesia

change in change in # of persons
income per living below
capita poverty line
1984-96 +76% -25%
1997-99 -12% +65%

CHAPTER 7 Economic Growth I slide 5

 Income and poverty in the world
selected countries, 2000
100
Madagascar
90
India
living on $2 per day or less

80 Nepal
70 Bangladesh
% of population

60 Kenya Botswana
50 China
40 Peru
Mexico
30 Thailand
20
Brazil Chile
10 Russian
S. Korea
Federation
0
$0 $5,000 $10,000 $15,000 $20,000
Income per capita in dollars

CHAPTER 7 Economic Growth I slide 6

 The importance of
economic growth

…for poor countries

…for rich countries

CHAPTER 7 Economic Growth I slide 7

Huge effects from tiny differences

In rich countries like the U.S.,

if government policies or “shocks”
have even a small impact on the
long-run growth rate,
they will have a huge impact
on our standard of living
in the long run…

CHAPTER 7 Economic Growth I slide 8

Huge effects from tiny differences

annual percentage increase in

growth rate standard of living after…
of income
per capita …25 years …50 years …100 years

2.0% 64.0% 169.2% 624.5%

2.5% 85.4% 243.7% 1,081.4%

CHAPTER 7 Economic Growth I slide 9

Huge effects from tiny differences

If the annual growth rate of

U.S. real GDP per capita
had been just
one-tenth of one percent higher
during the 1990s,
the U.S. would have generated
an additional $449 billion of income
during that decade

CHAPTER 7 Economic Growth I slide 10

The lessons of growth theory
…can make a positive difference in the
lives of hundreds of millions of people.

These lessons help us

 understand why poor
countries are poor
 design policies that
can help them grow
 learn how our own
growth rate is affected
by shocks and our
government’s policies

CHAPTER 7 Economic Growth I slide 11

 The Solow Model
 due to Robert Solow,
won Nobel Prize for contributions to
the study of economic growth
 a major paradigm:
– widely used in policy making
– benchmark against which most
recent growth theories are compared
 looks at the determinants of economic
growth and the standard of living in the
long run

CHAPTER 7 Economic Growth I slide 12

How Solow model is different from
Chapter 3’s model
1. K is no longer fixed:
investment causes it to grow,
depreciation causes it to shrink.

2. L is no longer fixed:
population growth causes it to grow.

3. The consumption function is even simpler.

CHAPTER 7 Economic Growth I slide 13

How Solow model is different from
Chapter 3’s model
4. No G or T
(only to simplify presentation;
we can still do fiscal policy experiments)

5. Cosmetic differences.

CHAPTER 7 Economic Growth I slide 14

 The production function
 In aggregate terms: Y = F (K, L )
 Define: y = Y/L = output per worker
k = K/L = capital per worker
 Assume constant returns to scale:
zY = F (zK, zL ) for any z > 0
 Pick z = 1/L. Then
Y/L = F (K/L , 1)
y = F (k, 1)
y = f(k) where f(k) = F (k, 1)

CHAPTER 7 Economic Growth I slide 15

 The production function
Output per
worker, y
f(k)

MPK =f(k +1) – f(k)

1

Note: this production function

exhibits diminishing MPK.

Capital per
worker, k
CHAPTER 7 Economic Growth I slide 16
 The national income identity

 Y=C+I (remember, no G )

 In “per worker” terms:

y=c+i
where c = C/L and i = I/L

CHAPTER 7 Economic Growth I slide 17

 The consumption function

 s = the saving rate,

the fraction of income that is saved
(s is an exogenous parameter)
Note: s is the only lowercase variable
that is not equal to
its uppercase version divided by L

 Consumption function: c = (1–s)y

(per worker)

CHAPTER 7 Economic Growth I slide 18

 Saving and investment
 saving (per worker) = y – c
= y – (1–s)y
= sy
 National income identity is y = c + i
Rearrange to get: i = y – c = sy
(investment = saving, like in chap. 3!)

 Using the results above,

i = sy = sf(k)
CHAPTER 7 Economic Growth I slide 19
Output, consumption, and investment

Output per f(k)

worker, y

c1
y1 sf(k)

i1

k1 Capital per
worker, k
CHAPTER 7 Economic Growth I slide 20
 Depreciation

Depreciation  = the rate of depreciation

per worker, k = the fraction of the capital stock
that wears out each period

k


1

Capital per
worker, k
CHAPTER 7 Economic Growth I slide 21
 Capital accumulation

The basic idea:

Investment makes
the capital stock bigger,
depreciation makes it smaller.

CHAPTER 7 Economic Growth I slide 22

 Capital accumulation

Change in capital stock = investment – depreciation

k = i – k

Since i = sf(k) , this becomes:

k = s f(k) – k

CHAPTER 7 Economic Growth I slide 23

 The equation of motion for k

k = s f(k) – k
 the Solow model’s central equation
 Determines behavior of capital over time…
 …which, in turn, determines behavior of
all of the other endogenous variables
because they all depend on k. E.g.,
income per person: y = f(k)
consump. per person: c = (1–s) f(k)

CHAPTER 7 Economic Growth I slide 24

 The steady state

k = s f(k) – k
If investment is just enough to cover depreciation
[sf(k) = k ],
then capital per worker will remain constant:
k = 0.

This constant value, denoted k*, is called the

steady state capital stock.

CHAPTER 7 Economic Growth I slide 25

 The steady state

Investment
and k
depreciation
sf(k)

k* Capital per
worker, k
CHAPTER 7 Economic Growth I slide 26
 Moving toward the steady state

k = sf(k)  k
Investment
and k
depreciation
sf(k)

k
investment

depreciation

k1 k* Capital per
worker, k
CHAPTER 7 Economic Growth I slide 27
 Moving toward the steady state

k = sf(k)  k
Investment
and k
depreciation
sf(k)

k

k1 k2 k* Capital per
worker, k
CHAPTER 7 Economic Growth I slide 28
 Moving toward the steady state

k = sf(k)  k
Investment
and k
depreciation
sf(k)

k
investment
depreciation

k2 k* Capital per
worker, k
CHAPTER 7 Economic Growth I slide 29
 Moving toward the steady state

k = sf(k)  k
Investment
and k
depreciation
sf(k)

k

k2 k3 k* Capital per
worker, k
CHAPTER 7 Economic Growth I slide 30
 Moving toward the steady state

k = sf(k)  k
Investment
and k
depreciation

Summary: sf(k)
As long as k < k*,
investment will exceed
depreciation,
and k will continue to
grow toward k*.

k3 k* Capital per
worker, k
CHAPTER 7 Economic Growth I slide 31
A numerical example
Production function (aggregate):
Y  F (K , L )  K  L  K L
1/2 1/2

To derive the per-worker production function,

divide through by L:
1/2
Y K L 1/2 1/2
K 
  
L L L 

Then substitute y = Y/L and k = K/L to get

y  f (k )  k 1/2

CHAPTER 7 Economic Growth I slide 32

A numerical example, cont.

Assume:
 s = 0.3
  = 0.1
 initial value of k = 4.0

y  f (k )  k 1 / 2

CHAPTER 7 Economic Growth I slide 33

 Approaching the Steady State:
A Numerical Example

Year k y c i k k
1 4.000 2.000 1.400 0.600 0.400 0.200
2 4.200 2.049 1.435 0.615 0.420 0.195
3 4.395 2.096 1.467 0.629 0.440 0.189
4 4.584 2.141 1.499 0.642 0.458 0.184
…
10 5.602 2.367 1.657 0.710 0.560 0.150
…
25 7.351 2.706 1.894 0.812 0.732 0.080
…
100 8.962 2.994 2.096 0.898 0.896 0.002
…
 9.000 3.000 2.100 0.900 0.900 0.000
CHAPTER 7 Economic Growth I slide 34
Exercise: solve for the steady state
Continue to assume
s = 0.3,  = 0.1, and y = k 1/2

Use the equation of motion

k = s f(k)  k
to solve for the steady-state values of
k, y, and c.

CHAPTER 7 Economic Growth I slide 35

 Solution to exercise:
k  0 def. of steady state
s f (k *)   k * eq'n of motion with k  0
0.3 k *  0.1k * using assumed values
k*
3  k*
k*
Solve to get: k *  9 and y *  k *  3
Finally, c *  (1  s )y *  0.7  3  2.1

CHAPTER 7 Economic Growth I slide 36

 An increase in the saving rate
An increase in the saving rate raises investment…
…causing the capital stock to grow toward a new steady state:
Investment
and k
depreciation s2 f(k)
s1 f(k)

k
k 1
*
k *
2

CHAPTER 7 Economic Growth I slide 37

 Prediction:
 Higher s  higher k*.

 And since y = f(k) ,

higher k*  higher y* .

 Thus, the Solow model predicts that countries

with higher rates of saving and investment
will have higher levels of capital and income
per worker in the long run.

CHAPTER 7 Economic Growth I slide 38

 International Evidence on Investment
Rates and Income per Person
Income per
person in 1992
(logarithmic scale)
1 00 ,00 0

Canada
U.S. Denmark Germ any Japan

1 0,0 00 Finland
Mexico U.K.
Brazi l Singapore
Israel
France y
It al
Paki stan
Egypt Ivory
Coast Peru

Indonesi a
1 ,00 0
India Zimbabwe
Kenya
Uganda
Chad Cam eroon

1 00
0 5 10 15 20 25 30 35 40
Investment as percentage of output
(average 1960 –1992)
CHAPTER 7 Economic Growth I slide 39
 The Golden Rule: introduction
 Different values of s lead to different steady states.
How do we know which is the “best” steady state?
 Economic well-being depends on consumption,
so the “best” steady state has the highest possible
value of consumption per person: c* = (1–s) f(k*)
 An increase in s
• leads to higher k* and y*, which may raise c*
• reduces consumption’s share of income (1–s),
which may lower c*
 So, how do we find the s and k* that maximize c* ?

CHAPTER 7 Economic Growth I slide 40

The Golden Rule Capital Stock
k gold
*
 the Golden Rule level of capital,
the steady state value of k
that maximizes consumption.
To find it, first express c* in terms of k*:
c* = y*  i*
In general:
= f (k*)  i* i = k + k
= f (k*)  k* In the steady state:
i* = k*
because k = 0.

CHAPTER 7 Economic Growth I slide 41

 The Golden Rule Capital Stock
steady state
output and
depreciation k*
Then, graph
f(k*) and k*, f(k*)
and look for the
point where the
gap between
them is biggest.
c gold
*

i gold
*
  k gold
*

y gold
*
 f (k gold
*
) k gold
*
steady-state
capital per
worker, k*
CHAPTER 7 Economic Growth I slide 42
 The Golden Rule Capital Stock

c* = f(k*)  k* k*

is biggest where
the slope of the f(k*)
production func.
equals
the slope of the c gold
*

depreciation line:
MPK = 
k gold
*
steady-state
capital per
worker, k*
CHAPTER 7 Economic Growth I slide 43
Use calculus to find golden rule

We want to maximize: c* = f(k*)  k*

From calculus, at the maximum we know the

derivative equals zero.

Find derivative: dc*/dk*= MPK 

Set equal to zero: MPK  = 0 or MPK = 

CHAPTER 7 Economic Growth I slide 44

 The transition to the
Golden Rule Steady State
 The economy does NOT have a tendency to
move toward the Golden Rule steady state.
 Achieving the Golden Rule requires that
policymakers adjust s.
 This adjustment leads to a new steady state
with higher consumption.
 But what happens to consumption
during the transition to the Golden Rule?

CHAPTER 7 Economic Growth I slide 45

 Starting with too much capital
If k *  k gold
*

then increasing y
c* requires a
fall in s.
In the transition c
to the
i
Golden Rule,
consumption is
higher at all
points in time. t0 time

CHAPTER 7 Economic Growth I slide 46

 Starting with too little capital
If k *  k gold
*

then increasing c*
requires an y
increase in s.
Future generations c
enjoy higher
consumption,
but the current one
i
experiences
an initial drop
in consumption. t0 time

CHAPTER 7 Economic Growth I slide 47

 Population Growth
 Assume that the population--and labor force--
grow at rate n. (n is exogenous)
L
 n
L
 EX: Suppose L = 1000 in year 1 and the
population is growing at 2%/year (n = 0.02).
Then L = n L = 0.02  1000 = 20,
so L = 1020 in year 2.

CHAPTER 7 Economic Growth I slide 48

 Break-even investment
( + n)k = break-even investment,
the amount of investment necessary
to keep k constant.

Break-even investment includes:

  k to replace capital as it wears out
 n k to equip new workers with capital
(otherwise, k would fall as the existing
capital stock would be spread more thinly
over a larger population of workers)

CHAPTER 7 Economic Growth I slide 49

 The equation of motion for k
 With population growth, the equation of
motion for k is

k = s f(k)  ( + n) k

actual
investment break-even
investment

CHAPTER 7 Economic Growth I slide 50

 The Solow Model diagram
Investment,
k = s f(k)  ( +n)k
break-even
investment
( + n ) k

sf(k)

k* Capital per
worker, k
CHAPTER 7 Economic Growth I slide 51
 The impact of population growth
Investment,
break-even ( +n2) k
investment
( +n1) k
An increase in n
causes an sf(k)
increase in break-
even investment,
leading to a lower
steady-state level
of k.

k 2* k1* Capital per

worker, k
CHAPTER 7 Economic Growth I slide 52
 Prediction:
 Higher n  lower k*.

 And since y = f(k) ,

lower k*  lower y* .

 Thus, the Solow model predicts that

countries with higher population growth
rates will have lower levels of capital and
income per worker in the long run.

CHAPTER 7 Economic Growth I slide 53

 International Evidence on Population
Income per Growth and Income per Person
person in 1992
(logarithmic scale)
100,000

Germ any
Denmark U.S.
Canada

Israel
10,000 Japan Singapore Mexico
U.K.
Finland France
It al y
Egypt Brazi l

Paki stan Ivory

Peru Coast
Indonesi a
1,000 Cam eroon
Kenya
India
Zimbabwe
Chad Uganda

100
0 1 2 3 4
Population growth (percent per y ear)
(average 1960 –1992)
CHAPTER 7 Economic Growth I slide 54
The Golden Rule with Population Growth
To find the Golden Rule capital stock,
we again express c* in terms of k*:
c* = y*  i*
= f (k* )  ( + n) k*
c* is maximized when In the Golden
MPK =  + n Rule Steady State,
the marginal product of
or equivalently, capital net of
MPK   = n depreciation equals the
population growth rate.
CHAPTER 7 Economic Growth I slide 55
 Chapter Summary
1. The Solow growth model shows that, in the
long run, a country’s standard of living depends
 positively on its saving rate.
 negatively on its population growth rate.

2. An increase in the saving rate leads to

 higher output in the long run
 faster growth temporarily
 but not faster steady state growth.

CHAPTER 7 Economic Growth I slide 56

 Friendly quiz #2
Write answers to the following 4 questions on a
sheet of paper to hand in (each worth 1 point).
1) Your name
2) Your TA’s name (Yi or Mei)
3) Compute the real wage for the case:

Y  12K L 12 12
K  100, L  100
4) What happens to the real wage if there is a
rise in the amount of capital (rise, fall, no
change)
CHAPTER 7 Economic Growth I slide57
57
slide
 Quiz answers
W
3)  MPL  6K 1 2L1 2
P
 6  1001 2100 1 2  6

4) a rise in K raises the MPL, so this

causes the real wage to rise.

CHAPTER 7 Economic Growth I slide58

58
slide
CHAPTER 7 Economic Growth I slide 59