1. Three Lectures on Economic Efficiency and Growth
CES ifo
Thorvaldur Gylfason

2. Outline and aims
Present a policy-oriented overview of the theory and empirical evidence of economic growth
Trace linkages between economic growth and its main determinants: saving, investment, and economic efficiency
Exogenous vs. endogenous growth
Liberalization, stabilization, privatization
Education, institutions, natural resources

3. Outline and aims Lecture I Lecture II Lecture III
Saving, efficiency, and economic growth
Lecture II
Economic policy and growth
Lecture III
Education, natural resources, institutions, and empirical evidence

4. 1 Introduction Growth theory Why important? As old as economics itself
Smith, Marshall, Schumpeter, Keynes
Explicit growth theory started with Harrod and Domar in 1940s
Why important?
Unfashionable in 1960s and 1970s
Limits to growth, etc.
Growth and development

5. Growing apart Investment Efficiency Institutions Policy
Country B: 2% a year
Investment
Efficiency
Institutions
Policy
GNP per capita
Threefold difference after 60 years
Country A: 0.4% a year 60
Years

6. The short run vs. the long run
Economic growth:
The short run vs. the long run
Economic growth
in the long run
Potential output
Actual output
Upswing
National economic output
Business cycles
in the short run
Downswing
Time

7. Other comparisons West-Germany vs. East-Germany
Austria vs. Czech Republic
US vs. USSR
South Korea vs. North Korea
Taiwan vs. China
Finland vs. Estonia
See my Pictures of Growth
China vs. Europe:
1:1 in 1400
1:20 in 1989

8. Further comparisons Thailand vs. Burma Mauritius vs. Madagascar
Botswana vs. Nigeria
Tunisia vs. Morocco
Spain vs. Argentina
Dominican Republic vs. Haiti

9. Singapore and Malaysia: GNP per capita 1962-2001
6.1%
Current US$,
Atlas method
(1.02)40 = 2.2
4.1%

10. Botswana and Nigeria: GNP per capita 1962-2001
Current US$,
Atlas method

11. Spain and Argentina : GNP per capita 1962-2001
Current US$,
Atlas method

12. Mauritius and Madagascar: GNP per capita 1962-2001
Current US$,
Atlas method

13. Ireland and Greece: GNP per capita 1962-2001
Current US$,
Atlas method

14. Basic growth theory Harrod-Domar model Solow model
Endogenous growth model
Let’s do the algebra

15. Harrod-Domar model A Two assumptions Implications for growth gross net
Fixed saving rate
Fixed capital/output ratio
Implications for growth
gross
net
replacement

16. Harrod-Domar model Three propositions about growth v = K/Y 1/v = Y/K
Saving increases growth
Efficiency increases growth
v = K/Y
1/v = Y/K
Depreciation reduces growth

17. Solow model B Four assumptions Output growth equals labor force growth
Full employment
Constant growth of labor force
Constant returns to scale
Saving equals investment

18. Solow model Endogenous output/capital ratio Exogenous Exogenous
Need to determine k and hence y/k

19. Solow model Dynamic stability of output/capital ratio
Stable equilibrium

20. Solow model Dynamic stability of output/capital ratio E
Stable equilibrium E

21. Solow model Two equations in two unknowns, y and k
Long-run equilibrium

22. Solow model E Comparative statics:
Output per head
Comparative statics:
E moves in response to changes in s, A, n, and 
Output/capital ratio
Capital per worker

23. Solow model Four propositions about long-run growth
Increased saving increases income per capita
Increased efficiency increases income per capita
Increased population growth reduces income per capita
Increased depreciation reduces income per capita

24. Closed-form solution to Solow model
Labor-augmenting
technological progress

25. Closed-form solution to Solow model

26. Closed-form solution to Solow model
a(+n+q) is the speed of convergence

27. Closed-form solution to Solow model
time

28. Solow model: Convergence
Takes 17 years to close half the gap
Takes 40 years to close 80% of the gap

29. Solow model: Convergence
Output per head
Rich country’s
initial income per head
Poor country must grow
faster if it is to catch up
Poor country’s
initial income per head
Capital per worker

30. An Increase in the Saving RateP F
Output per head E
Capital per worker

31. An Increase in Static EfficiencyP’ F P
Output per head E
Capital per worker

32. An Increase in Population Growth or Depreciation
Output per head F
Capital per worker

33. An Increase in Dynamic Efficiency (Technical Progress)
Output per head E
Capital per worker

34. Solow model: Conclusion
Three main points to note
Long-run growth is exogenous: g = n + q
No role for economic forces, policy or institutions, just technology
But education is good for growth
Model implies convergence
Poor countries grow more rapidly than rich
The medium term can be quite long
Growth is endogenous for a long while

35. Solow model with education
H = skilled labor
L = raw labor, b = years of schooling
AH grows at n + q + b
Education stimulates long-run growth

36. Endogenous growth C Two equations in two unknowns, g and q
E = efficiency
E = 1/v in Harrod-Domar
Harrod-Domar, again, without the drawbacks
Two equations in two unknowns, g and q

37. Endogenous growth Let’s take four examples C A B O Saving rate
times efficiency
minus depreciation
Economic growth, g C A B
45° O
Technological progress, q
Population growth

38. 1 A tax on education and endogenous growth A tax to finance education
G = government spending on education
G is financed by tax on capital
Constant returns to capital
A tax to finance education
is good for growth

39. 2 Inflation, money, and endogenous growth Inflation impedes growth
Output is made by financial and real capital
Inflation reduces the use of financial capital
Inflation impedes growth

40. 3 Education and endogenous growth, again R&D model (Romer)
b = fraction of labor force engaged in R&D
bL = number of workers engaged in R&D
A = stock of existing knowledge
Growth depends on R&D

41. 4 Education and endogenous growth, once more
Human capital model (Lucas)
c = human capital
Less education means less growth
h = fraction of time spent on work
Let’s look at some evidence, but first …

42. How growth becomes endogenous
Solow model: when s rises, E = Y/K falls due to decreasing returns to capital, so g stays put
Endogenous growth: when s rises, E stays put due to constant returns to capital, so g rises

43. Empirical growth research
Cross-country regressions
Large samples, beginning in 1960 or 1970
Cross sections vs. panels
Averages vs. initial values of independent variables
Cost of simultaneity bias vs. cost of discarding available data
Recursive modeling vs. instruments
Levels of income vs. rates of growth

44. Recursive modeling Growth regression g = a0 – a1y0 + a2x + a3z (1)
where x is exogenous and z is endogenous
z = b0 + b1y0 – b2x (2)
where z is, say, education and x is natural resource reliance
Eq. (2) makes z exogenous, so (1) and (2) can be estimated by OLS
TSLS calls for instruments that help explain z without being correlated with g: Not easy

45. Levels of income vs. rates of growth

46. Levels of income vs. rates of growth

47. Levels of income vs. rates of growth

48. Levels of income vs. rates of growth

49. Levels of income vs. rates of growth
Conditional convergence requires b >  < 1
One-to-one correspondence between parameters

50. Absolute convergence: Growth rates
Equatorial
Guinea
b = 0.864
165 countries

51. Absolute convergence: Levels of income
= 0.658
= 1 – 0.40.864
Equatorial
Guinea
Conditional convergence is stronger, as we will see
45º
165 countries

52. From efficiency to growth
Basic result
If it – anything! – increases economic efficiency, it is also good for growth
Follows from Harrod-Domar model as well as from endogenous-growth theory and also, as a proposition about the medium run, from the Solow model
In practice, Solow model and endogenous growth are hard to distinguish
So, let’s look more closely at efficiency

53. Liberalization Increases Economic EfficiencyD
Domestic, distorted price ratio H E
Traditional output C G
Modern output O

54. Liberalization Increases Economic Efficiency
World price ratio D
Domestic, distorted price ratio H E
If output gain = E and price distortion = c, then E = mc2
Traditional output
Output gain
Price distortion
OC = modern output
CA = traditional output
OA = total output F C A G B
Modern output O

55. Liberalization Increases Economic Efficiency
Welfare gain
World price ratio
Exports D
Domestic, distorted price ratio J K H E
Traditional output
Output gain
Price distortion
Imports F C A G B
Modern output O

56. Liberalization Increases Economic Efficiency
Transition takes time: From E to F via M, N, and Q
Welfare gain D J H E M
Traditional output N
Price distortion Q F C A G B
Modern output O

57. Liberalization Increases Economic Efficiency
Welfare
gain
World price
ratio K D J
Productivity gain E
Traditional output
AB = static gain
BC = dynamic gain
AC = AB + BC = total gain
Price
distortion H F A G
Modern output O B C

58. Stabilization Increases Economic Efficiency
Distorted
price ratio
If output gain = E and inflation distortion = c, then, again, E = mc2 D
Inflation
distortion C E
Output gain F
Undistorted
price ratio
Real capital G
Output after
Output before
45° H
Financial capital O A B

59. Privatization Increases Economic Efficiency
Undistorted
price ratio D E
Distorted
price ratio H
Public output
Price and
quality
distortion F J
Output gain
45° O N
Private output A K G B

60. From efficiency to growth: Same story time and again
Free trade is good for growth
Reduces the inefficiency that results from restrictions on trade
Price stability is good for growth
Reduces inefficiency resulting from inflation
Privatization is good for growth
Reduces inefficiency resulting from SOEs
Education is good for growth
Reduces the inefficiency that results from inadequate education

61. Investment and growth, 1965-1998
An increase in investment by 4% of GDP is associated with an increase in per capita growth by 1% per year
Botswana
Thailand
r = rank correlation
Jordan 1% 4%
Nicaragua
r = 0.65
85 countries

62. Education and growth, 1965-1998 87 countries
A 25 point increase in secondary-school enrolment goes along with an increase in per capita growth by 1% per year
Thailand
Japan
Finland
Diminishing returns: The additional benefit from education becomes smaller as enrolment increases
Ghana
r = 0.72
87 countries

63. Natural resources and growth, 1965-1998
An increase in the natural capital share by 8% goes along with a decrease in per capita growth by 1% per year
Mauritius
Cameroon
Mali
Madagascar
r = -0.64
85 countries

64. Democracy and growth, 1965-1998 Democracy and growth go together
Equatorial
Guinea
Botswana
Singapore
Korea
Cyprus
Saudi-Arabia
Malaysia
China
Now, let’s run some regressions
r = 0.48
144 countries

65. Growth regressions Based on World Bank data
World Development Indicators, published each year on CD
Wide coverage: 208 countries, 42 years
Could also use Penn data (compiled by Summers and Heston), but they cover fewer countries
Here, we report cross-sectional evidence, representing each country by a single observation for each variable

66. POLITY2 describes democracy on a scale from -10 to 10
Keep an eye on the number of observations
An increase in democracy by 15 points (e.g., from –7 to 8) increases growth by 1 percentage point

67. INITIAL is the log of per capita GNP in 1960, so the coefficient describes the speed of convergence

68. PRIMGDP is the share of primary production in GDP
An increase in the share of primary production in GDP by 14% increases growth by 1 percentage point

69. INVEST is the ratio of investment to GDP
An increase in investment by 9% of GDP increases growth by 1 percentage point

70. LOGENROL is the log of secondary-school enrolment (net)
An increase in secondary-school enrolment by 100% (e.g., from 40% to 80%) increases growth by nearly 1 percentage point

71. DISTORT = /(1+ )
A decrease in inflation from 50% to zero increases growth by nearly 1 percentage point

72. DUMMYAFR is a dummy for sub-Saharan Africa

73. Dependent variable is now the level of per capita GNP: same story
Conditional convergence, as before

74. BIRTHS is the number of births attended by skilled medical staff (%)
BIRTHS makes African dummy redundant

75. Grand finale
Dependent variable: per capita growth , R2 = 0.68
If Panama became like Costa Rica, growth would rise by 1%
Effects of democracy
Growth equation
Total effect of democracy on growth is = 0.103
Investment equation
Education equation
Health equation
Democracy equation

76. Grand finale
Dependent variable: per capita growth , R2 = 0.68
Effect of primary production on growth
Effects of natural resources
Growth equation
Total effect of primary share on growth is = 0.062
Investment equation
Education equation
Health equation
Democracy equation

77. The End Conclusion Saving and efficiency are good for growth
Efficiency gains take many different forms
The End
Liberalization, stabilization, privatization
Conversion of inputs into output is not solely a matter of technology, but also efficiency, so economic policy matters

78. Classroom discussion