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1 Economic Growth Professor Chris Adam Australian Graduate School of Management University of Sydney and University of New South Wales

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2 INTRODUCTION Observe rising incomes and standards of living Know that level of GDP driven by –Capital –Labour –Technology Changes in GDP must come from changes in factors

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3 REAL GROWTH

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4 GROWTH OF COUNTRIES

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5 GROWTH MODEL Solow-Swan growth model (1956) –“Dynamic capital accumulation” –Can explain how growth occurs –Can explain differences in growth –Key elements are savings and population growth –Technological progress also important but not covered here

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6 GROWTH MODEL Supply of goods and production Y = F(K, L) –Constant returns to scale –Analyze all quantities relative to labour force: Y/L = F(K/L, 1) or y = f(k)

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7 GROWTH MODEL Supply of goods and production –Slope of function is marginal productivity of capital per worker –Slope declines with increased capital per worker

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8 LABOUR PRODUCTIVITY

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9 GROWTH MODEL Demand for goods and consumption –Output per worker divided between consumption goods and investment goods y = c + i –Omits government and international sectors

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10 GROWTH MODEL Demand for goods and consumption –Savings is fraction 0 < s < 1 of income, so consumption is c = (1 – s)y –Implies investment equals saving: i = sy

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11 USING GROWTH MODEL Capital stock growth and steady state –Investment (i) increases capital stock = savings (sf(k)) increases capital stock –Depreciation reduces capital stock: depreciation rate = –Change in capital stock k then k = i – k

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12 USING GROWTH MODEL Capital stock growth and steady state –Steady state when k = 0 –implying i = sf(k*) = k* for k* steady state (constant) capital per worker

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13 USING GROWTH MODEL How savings affects growth –Increased savings rate (s) means less consumption per worker and more investment –Leads to higher level of capital stock per worker (k) –Strong empirical support

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14 SAVINGS

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15 USING GROWTH MODEL What determines savings rates? Similar investment rates do not always produce same income per worker – what else matters?

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16 GOLDEN RULE OF GROWTH Is more savings always good? –Gives larger capital stock per worker and higher output per worker –But reduces consumption per worker Want to compare steady states to see which has highest consumption per worker

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17 GOLDEN RULE OF GROWTH Consider level of consumption at steady state c* = f(k*) – k* Consumption is what is left of steady state output after allowing for steady state depreciation Set level of savings to ensure c* is maximized: this is Golden Rule Savings –occurs when marginal product of k equals

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18 TRANSITION TO GOLDEN RULE Too much capital per worker: –Policy maker lowers saving rate to Golden Rule level –Increases consumption and reduces investment –Investment rate now below depreciation rate –Reduces output, investment further –Consumption decreases from peak, but will remain above original level since at Golden Rule

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19 TRANSITION TO GOLDEN RULE Too little capital per worker: –Policy maker increases saving rate to Golden Rule level –Reduces consumption and increases investment –Investment rate now above depreciation rate –Increases output, investment further –Consumption increases from dip, and will remain above original level since at Golden Rule

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20 POPULATION GROWTH Growth in population increases workforce –Dilutes capital and output per worker at steady state –Population growth rate (n) reduces capital stock per worker in same way as depreciation k = i – (+ n)k = sf(k) – (+ n)k Steady state k* from k = 0 = sf(k*) – (+ n)k*

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21 POPULATION GROWTH Growth in population has three effects on growth: –Better view of sustained growth drivers: total output grows –Better view of national income differences: higher population grow lowers GDP per person –Golden Rule adjusted: now marginal product of capital per worker to equal ( + n)

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22 TAKEAWAYS Solow-Swan model shows –How saving sets steady state capital stock per worker and steady state income per worker –How population growth sets steady state capital stock per worker and steady state income per worker –What policy makers might do to maximize consumption per worker in steady state

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Lecture 4: The Solow Growth Model

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