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PSME M1 Economic Growth Tutorial

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Introduction ◦ Review of Classic Solow Model ◦ Shortfalls of Solow ◦ Human Capital Accumulation ◦ Convergence Theory and Model Prediction Theoretical Solow Model ◦ Estimation results of Classic Solow Model and Analysis ◦ Augmented Solow Model and its Predictions ◦ Estimation results of Augmented Solow Model and Analysis Endogenous Growth and Convergence

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Paper by Mankiw, Romer and Weil Published in The Quarterly Journal of Economics, Vol 107, No. 2, 1992, pg 407- 437 Paper examines whether the Solow growth model is consistent with international variation in the standard of living

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Paper aims to fill up some shortfallings of the Solow model Solow model is augmented with human capital as well as physical capital accumulation An augmented Solow model is a better representation of cross-country data Prediction of the model is that by holding the population growth and capital accumulation constant, countries converge in terms of standards of living at a given Solow convergence rate

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Standard neoclassical production function with decreasing returns to capital (and labor) Treat savings and population rate as exo (s and n are given) s and n determine the steady-state level of income per capita [(f(k*)] ={(n+δ)/s} k*) If s is higher, then f(k*) is larger -> the higher the saving rate, the richer the country If n is higher, then f(k*) is smaller –> the higher the pop rate, the poorer the country

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Using cross-country data, paper finds that s and n affect income in the directions predicted by Solow Problem is that the magnitudes are not coherant Might be omitted variables so need to include human capital accumulation

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For any given rate of human capital accumulation, higher s or lower n leads to higher f(k*) and thus a higher level of H* Human capital accumulation may be correlated with s and n, leading to omitted variable bias According to paper, the augmented Solow model provides an almost complete explanantion (80% of country income variation is explained) of why some countries are rich and others are poor

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The article argues that there is no absolute convergence (countries need not converge in per capita income) Rather, there is conditional convergence (countries generally converge to their respectively different steady state incomes) Finally, the model predicts that poor countries tend to have higher rates of return to physical and human capital

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Given exo s, n and g (rate of tech progress) and a Cobb-Douglas production function Solow predicts α=1/3

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3 aspects of model is supported (1) Coefficients of s and n have predicted signs and are highly sig (2) Restriction on coefficients of s and (n+g+δ) is not rej (3) Differences in s and n account for a large fraction of cross-country variation (R^2=0.59) Problem with α (≠ 1/3 as predicted)

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Human capital accumulation increases the impact of physical capital on income High population growth lowers income per capital because the amounts of both physical and human capital must be spread more thinly over the population Use percentage of working-age pop that is in secondary school as a proxy for human capital accumulation

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Human capital is significant is all three samples Size of coefficient on physical capital accumulation is reduced Fit of regression is improved The paper concludes that adding human capital to the Solow model improves its performance

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Endogenous growth models are characterized by non-decreasing returns to inputs Implies that countries that save more grow faster indefinitely and countries need not converge in income per capital even if they have the same preferences and technology The Solow model predicts that countries reach different steady states (conditional convergence at the rate the model predicts)

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The paper argues that the Solow model is consistent with the international evidence when augmented with human and physical capital The augmented Solow model says that differences in saving, education and population growth should explain cross-country differences in income per capita Direct further research on exo variables that vary across countries eg diff in tax policies, education policies, etc

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Economic models …are simplied versions of a more complex reality irrelevant details are stripped away Used to show the relationships between economic variables.

Economic models …are simplied versions of a more complex reality irrelevant details are stripped away Used to show the relationships between economic variables.

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