Macroeconomics

Ninth Canadian Edition

Chapter 6
Long-Run Economic Growth

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Calculating Growth Rates
Year-to-year growth rate of an economic variable like real GDP or real
GDP per capita is equal to the percentage change from the previous
year.
Year Real GDP  $2125 billion  $2058 billion 
   100%  3.3%
2020 $2058 billion  $2058 billion 
2021 $2125 billion
To compute the average annual growth rate over a long period of time,
we use the following formula:

A is the start value, B is the end value,

g is the growth rate, and t is the number of years.

Real GDP per capita in 1961 was $20,000

Real GDP per capita in 2021 was $60,000

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Compute g.
Main Questions
• What are the sources of economic growth?
• What forces determine long-run living standards?
• What are government policies to influence the rate
of growth?

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The Sources of Economic Growth
• The relationship between output and inputs is
described by the production function

Y  AF ( K , N )

• For Y to grow, either quantities of K or N must

grow or productivity (A) must improve, or both.

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The Growth Accounting Equation (1 of 2)

• The growth accounting equation

Y A K N
  K  N
Y A K N
ΔY/Y is the rate of output growth,
ΔK/K is the rate of capital growth,
ΔN/N is the rate of labour growth,
ΔA/A is the rate of productivity growth,
all measured as percentage changes
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The Growth Accounting Equation (2 of 2)

αK = elasticity of output with respect to capital

(about 0.3 in Canada)
αN = elasticity of output with respect to labour
(about 0.7 in Canada)

The elasticity of output with respect to

capital/labour is the percentage increase in
output resulting from a one percent increase
in the amount of capital stock/labour.
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Growth Accounting (1 of 3)
• Growth accounting measures empirically the
relative importance of capital stock, labour and
productivity for economic growth.
• The impact of changes in capital and labour is
estimated from historical data.

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Growth Accounting (2 of 3)
• The impact of changes in total factor productivity
is treated as a residual, that is, not otherwise
explained.

A Y K N
  K N
A Y K N

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Growth Accounting (3 of 3)

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Growth Accounting and the
Productivity Slowdown (1 of 2)
• Rapid output growth during 1962–1973 has
slowed in 1974–2015.
• Much of the decline in output growth can be
accounted for by a decline in productivity growth.
• The slowdown in productivity since 1974 is
widespread.

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The Post-1973 Slowdown in
Productivity Growth (2 of 3)
• Explanations of the reduced growth in productivity
are
– Output measurement problem.
– The growth in oil prices.
• Other explanations, but none have proven entirely
satisfactory.

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The Neoclassical Growth Model

• Also known as the Solow model

Nobel laureate Economist Robert Solow developed
this model. The Solow model
– Clarifies how capital accumulation and economic
growth are interrelated.
– Demonstrates how a nation’s rate of economic growth
evolves over time.
– Explains the factors affecting a nation’s long-run
standard of living.
– is widely used in policy making.

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Solow model: The variables
National Income Identity:
Solow model assumes:
• Closed economy: no exports or imports
• No government sector: no taxes or government expenditures

We rewrite the national income identity:

Multiply both sides of the identity by

= +
where, , RGDP per worker

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Solow model: The variables (cont..)
In the Solow model, Real GDP per worker (y) is divided into consumption
per worker (c) and investment per worker (i):

Let s be the national saving rate, the fraction of total output per worker that
is saved. So national saving (per worker) is .

The rest is consumed. Consumption function (per worker):

Investment function (per worker):

Investment per worker = saving per worker

Note:
• s is the only lowercase variable
that is not equal to its uppercase version divided by N
• s is exogenously determined.

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Solow model: the production function

• The Aggregate production function;

• In this model we focus on the per worker

production function:

yt = Yt /Nt is output per worker in year t

kt = Kt /Nt is capital stock per worker in year t

At = the level of total factor productivity in year t

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Graph of the Per-Worker Production
Function

• The production function slopes upward.

• With more capital each worker produces more
output.
• The slope gets flatter at higher levels of capital per
worker.
• This reflects diminishing MPK.

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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
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Output, consumption, and investment
Output per
worker, y f(k)

c1
sf(k)
y1

i1
Capital per
k1 worker, k

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 Investment and Depreciation

Investment is the purchase of new capital. Investment increases the amount of

capital over time.
On The other hand, Depreciation decreases the amount of capital over time.
Depreciation rate The rate at which the capital stock declines, due to either
capital goods becoming worn out by use or becoming obsolete.
Let d be the (constant) depreciation rate.
Then the amount of depreciation is proportional to the capital-labour ratio

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Depreciation
Depreciation d = the rate of depreciation
per worker, d k = the fraction of the capital stock
that wears out each period

dk

d
1

Capital per
worker, k
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Capital accumulation
The basic idea: Investment increases the capital
stock, depreciation reduces it.

Change in capital stock = investment –

depreciation
k = i – dk

Since i = sf(k) , this becomes:

k = s f(k) – dk

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The equation of motion for k
k = s f(k) – dk
• 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)
consumption per person: c = (1 – s) f(k)

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 The steady state

Equilibrium in the Solow growth model occurs when

• The capital-labour ratio is constant
• This implies the real GDP per worker is also constant

We call this equilibrium a steady state.

Steady state An equilibrium in the Solow growth model in which the capital-
labour ratio and real GDP per worker are constant.

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

This occurs at one value of k, denoted k*,

called the steady state capital stock.

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 The steady state
Investment
and dk
depreciation
sf(k)

k* Capital per
worker, k
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 Moving toward the steady state
k = sf(k)  k
Investment
and k
depreciation
sf(k)

k

k

k1 k2 k* Capital per
worker, k
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 Moving toward the steady state
k = sf(k)  k
Investment
and k
depreciation
sf(k)

k
investment
depreciation

k2 k* Capital per
worker, k
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 Moving toward the steady state
k = sf(k)  k
Investment
and k
depreciation
sf(k)

k

k2 k* Capital per
worker, k
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 Moving toward the steady state
k = sf(k)  k
Investment
and k
depreciation
sf(k)

k

k2 k3 k* Capital per
worker, k
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 Moving toward the steady state
k = sf(k)  k
Investment
and k
depreciation
sf(k)
Summary:
As long as k < k*,
investment will
exceed
depreciation,
and k will
continue to grow
toward k*.

k3 k* Capital per
worker, k
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A numerical example
Suppose,

Assume s = 0.3, d = 0.1

Suppose the economy starts with

• Find initial level of output, consumption, savings, investment, and depreciation, all per person. Find
the value for △.

The equation for motion of capital:

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Evolution of capital per worker
△

Year 1 4 2 1.4 0.6 0.4 0.2

Year 2 4.2 2.049 1.434 0.6147 0.42 0.1947

Year 3 4.3947 2.0963 1.4674 0.6288 0.4394 0.1893

Steady
State

△ is getting smaller and smaller. Why?

Depreciation is rising at a constant rate
Investment is rising at a decreasing rate

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Solving for the steady state

k = s f(k) – dk
In the steady state, when capital per worker reaches a
certain value , k = 0. We have . Rewrite this as:

∗
𝑘 =9

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 Growth dies out!
Investment
and dk
depreciation
sf(k)

k0 k* Capital per
worker, k
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Growth stops when we hit the steady state

k = s f(k) – dk
In the steady state
k = 0.
By definition,
Therefore, = 0
Meaning all the per worker variables cease to grow. They all are functions of .

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 Labour force growth and the steady state

Let us assume that

– The population is growing
– At any point in time, a share of the population of working age is fixed
– Both the population and labour force grow at a fixed rate n.
If the labour force grows more quickly than the capital stock, then the capital-
labour ratio falls, known as dilution.
If the labour force is growing at rate n, the amount of dilution of the capital-
labour ratio is:

Now, to maintain a steady state, investment must equal the sum of

depreciation and dilution. We call this the break-even investment:

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Break-even investment
• (d + n)k = break-even investment,
the amount of investment necessary
to keep k constant.
• Break-even investment includes:
– dk to replace capital as it wears out
– n k to equip new workers with capital
(Otherwise, k would fall as the existing capital stock
is spread more thinly over a larger population of
workers.)

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

k = s f(k)  ( + n) k

actual
break-even
investment
investment

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 Equilibrium in the Solow growth model

Change in the capital-

labour ratio:

In the steady state, Δk = 0;

so k* is the equilibrium
capital-labour ratio if:

In the graph, notice that

Labour Force Growth in the Solow Model
the depreciation line has
been relabeled to break- Copyright © 2022 Pearson Canada Inc. 6–39
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 An increase in the population growth rate

What if the labour

force grows more
quickly?
The capital stock gets
diluted faster—
current investment
cannot keep up with
the growing labour
force.
The break-even
investment line
becomes steeper.
The steady-state
value of k* falls.
An Increase in the Labour Force Growth Rate

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 An increase in the population growth rate

Note that while the level

of real GDP per worker
will fall, the steady-state
growth rate of real GDP
per worker will not fall.
(The same would be true
for an increase in the
depreciation rate.)

An Increase in the Labour Force Growth Rate

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 Saving rates and growth rates

An increase in the saving

rate would
• Shift the investment
function up, and
• Result in a higher
steady-state level of the
capital-labour ratio.
• The increase in the
capital-labour ratio is
temporary. The growth
dies out.

An Increase in the Saving Rate

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Steady-State Consumption per Worker
(1 of 2)

Figure 6.2 (a) The Relationship of Consumption Per Worker to the Capital–Labour Ratio in the Steady
State, part a only

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Steady-State Consumption per Worker:
the golden rule of capital accumulation
(2 of 2)

Figure 6.2 (b) The Relationship of Consumption Per Worker to the Capital–Labour Ratio in the Steady
State, part b only

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Steady-State Consumption per Worker
(1 of 2)

• The model shows that economic policy focused

solely on increasing capital per worker may do little
to increase consumption possibilities of the country
citizens.

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Steady-State Consumption per Worker
(2 of 2)

• Empirical evidence shows that higher capital stock

does not lead to less consumption in the
long run.
• Thus, we will assume that an increase in the
steady-state capital-labour ratio raises steady-
state consumption per worker.

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The Model Implications (1 of 2)
• The economy’s capital-labour ratio has a tendency
to go to k*
• In this steady state the capital-labour ratio, output
per worker, and consumption per worker all
remain constant over time.
• The economy will remain in that steady state
forever, unless something changes

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The Model Implications (2 of 2)

• Lower n  Higher k*.

• Lower d  Higher k*
• Higher s  Higher k*
• And since y = f(k) ,
Higher k*  Higher y*.
• Increase in output per worker increases consumption per worker,
which improves the Standard of living

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Long-Run Living Standard and the
Saving Rate (1 of 2)
• A higher saving rate implies a higher living
standard.
• The increased saving rate raises output at every
level of capital per worker.
• A steady-state with higher output and
consumption per worker is attained in the long
run.

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Long-Run Living Standard and the
Saving Rate (2 of 2)
• An increase in the saving rate has a cost—a fall in
current period consumption.
• So, there is a trade-off between current and future
consumption.

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Long-Run Living Standard and
Population Growth (1 of 2)
• Increased population growth tends to lower living
standards.
• When the workforce is growing rapidly, a large
part of current output must be devoted to just
providing capital for the new workers to use.

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Long-Run Living Standard and
Population Growth (2 of 2)
• However, a reduction in population growth means
– Lower population, lower total productive capacity, and
lower political influence in the world.
– Lower ratio of working-age people to the population
and unsustainable pension system.

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Convergence(1 of 2)
• Unconditional convergence is a situation when the
poor countries eventually catch up to the rich
countries so that in the long run, living standards
around the world become more or less the same.

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Convergence (2 of 2)
• Conditional convergence is a situation when living standards will
converge only within a group of countries with similar characteristics
(similar s, d, n and the production function).

k = s f(k) – (n+d)k
• In the steady state, when capital per worker reaches a certain value ,
k = 0. We have . Rewrite this as:

Regardless of the initial k, they all will have a similar level of k in the
steady state, a similar standard of living.

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Long-Run Living Standard and
Productivity Growth (1 of 3)
• The model accounts for the sustained growth by
incorporating productivity growth.
• Increased productivity will improve living
standards
– It raises y at every k
– Then saving per worker increases
– And higher k* is attained

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Long-Run Living Standard and
Productivity Growth (2 of 3)
• A one-time productivity improvement shifts the
economy only from one steady state to a higher
one.
• Only continuing increases in productivity can
perpetually improve living standards.

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Limitation of the Neoclassical Growth
Theory
• The neoclassical growth model assumes, rather
than explains, productivity—the crucial
determinant of living standards.

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Endogenous Growth Theory (1 of 2)
• Endogenous growth theory tries to explain
productivity growth within the model
(endogenously).

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Endogenous Growth Theory (2 of 2)
• An implication of endogenous growth theory is
that a country’s growth rate depends on its rate of
saving and investment, not only on exogenous
productivity growth.

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Setup of the Endogenous Growth Model
(1 of 3)

• Assume that the number of workers remains

constant (and equal to 1).
• This implies that the growth rate of output per
worker is simply equal to the growth rate of output.

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Setup of the Endogenous Growth Model
(2 of 3)

• The aggregate production function is

Y = AK (6.12)

A is a positive constant

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Setup of the Endogenous Growth Model
(3 of 3)

• The marginal product of capital (MPK) is equal to

A and does not depend on the capital stock (K).
• The MPK is not diminishing, it is constant.

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Constant MPK and Human Capital
• One explanation of constant MPK is human
capital—the knowledge, skills, and training of
individuals.
• As an economy’s physical capital increases, its
human capital stock tends to increase in the same
proportion.

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Constant MPK and Research and
Development
• Another explanation of constant MPK is research
and development (R&D) activities which are
generated by increasing physical capital.
• The resulting productivity gains offset any
tendency for the MPK to decrease.

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The Model of Endogenous Growth (1 of 2)

• Assume that national saving, S, is a constant

fraction s of aggregate output, AK, so that S = sAK.
• In a closed economy I = S.
• The change in the capital is the difference between
investment in capital stock and depreciation.
ΔK = I – dK
ΔK = sAK – dK

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The Model of Endogenous Growth (2 of 2)

Dividing each side by K gives an expression for the growth rate of the
capital stock,

, Therefore, , We assumed A is constant, = 0.

So the growth rate of real GDP per worker depends on the national
saving rate.

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Implication of The Model of
Endogenous Growth
• The growth rate of output per worker depends on
the saving rate s.
• The endogenous growth model places greater
emphasis on saving, human capital formation and
R&D as sources of long-run growth.

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Economic Growth and the Environment
• The empirical facts have shown:
– In poor countries, increase in GDP often reduces
environmental quality.
– Once GDP reaches a certain threshold, environmental
quality begins to improve.

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Government Policies and Long-Run
Living Standards
• Government policies that are useful in raising a
country’s long-run standard of living are:
– Polices to raise the saving rate.
– Policies to raise the rate of productivity.

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Policies to Affect the Saving Rate
• By taxing consumption, using a PST, GST, or HST,
for example.
• By rewarding savers, RRSP, and TFSA for
example.
• A government can increase the amount that it
saves, that is, to reduce its deficit .
• Forced savings such as the CPP.

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Policies to raise productivity:
Improving Infrastructure
• Some research finds a link between productivity
and the quality of nation’s infrastructure.

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Building Human Capital (1 of 2)
• Recent research finds a strong connection
between productivity growth and human capital.
• Governments affect human capital through
education policies, training programs, health
programs, etc.

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Building Human Capital (2 of 2)
• Productivity growth may increase if barriers to
entrepreneurial activity are removed.

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Encouraging Research and
Development
• Direct government support of basic research is a
good investment for raising productivity
(universities and research institutions).
• Some economists believe that even commercially
oriented research deserves government aid.
• Tax credits for spending on R&D
• Enforce patents and copyrights.

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Industrial Policy
• Industrial policy is a growth strategy in which the
government attempts to influence the country’s
pattern of industrial development.
• The arguments for the industrial policy are
borrowing constraints and spillovers. The danger
is favouritism.

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Market Policy
• Market policy is government restriction on free
markets.
• Economists favour respect for property rights and
a reliance on free markets to allocate resources
efficiently.

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Social Insurance
• The reasons for government to interfere are
market failures and efficiency vs. equity trade-off.

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