1. Topic 1: Ireland’s long-run economic performance Readings Readings Abel & Bernanke or other macro textbook Abel & Bernanke or other macro textbook Chapter on long-run economic growth Chapter on long-run economic growth Solow model and convergence Solow model and convergence Honohan and Walsh (2002) Honohan and Walsh (2002) Blanchard (2002) Blanchard (2002)

2. The Solow Growth Model Also known as the “neoclassical” growth model Interactive experiments available at: http://www.fgn.unisg.ch/eurmacro/tutor/solow_index.html

3. Cobb-Douglas production function Y = A F(K, L) = A K  L (1-  ) Y = Output A = Total Factor Productivity (TFP) K = Capital input L = Labour input

4. TFP (A) A: Also called the “Solow residual” A: Also called the “Solow residual” Captures wide range of factors: Captures wide range of factors: State of technology State of technology Strength of economic and political institutions Strength of economic and political institutions Input utilization Input utilization Sectoral composition of output Sectoral composition of output Other stuff Other stuff

5. Sectoral composition of output A = economy-wide level of productivity A = economy-wide level of productivity Consider an economy with two sectors: Consider an economy with two sectors: 1. Agriculture = low productivity 1. Agriculture = low productivity 2. Manufacturing = high productivity 2. Manufacturing = high productivity If Agriculture shrinks and Manufacturing grows, then A increases If Agriculture shrinks and Manufacturing grows, then A increases

6.  = elasticity of Y w.r.t. K Exercise 1: Prove it! Exercise 1: Prove it!Also:  = capital’s share of output (1<  <0) Exercise 2: Prove it! Exercise 2: Prove it!

7. Per worker version divide by L y = Af(k) = A k  y = Af(k) = A k  where y = Y/L k = K/L Exercise 3: Prove it!

8. Law of motion for the capital stock: k t+1 = (1-  ) k t + i t Where: i = investment  = rate of depreciation

9. What happens to the capital stock if i t =  k t k t+1 = (1-  ) k t + i t k t+1 = k t -  k t + i t k t+1 = k t k t+1 = k t Let k* = steady-state capital stock y* = Af(k*) = steady-state output

10. If i t >  k t then capital stock is growing If i t <  k t then capital stock is shrinking

11. In a closed economy: Investment = Savings i = sy i = sAf(k) i = sAf(k) where s = savings rate

13. Convergence Conditional convergence Conditional convergence If two countries have the similar A and s, but different initial k, then they will converge If two countries have the similar A and s, but different initial k, then they will converge If a SOE, then s not important If a SOE, then s not important Absent obstacles, A’s shouldn’t be very different across advanced economies Absent obstacles, A’s shouldn’t be very different across advanced economies Evidence of conditional convergence among advanced economies Evidence of conditional convergence among advanced economies

14. Honohan and Walsh (2002) 1990s boom was a convergence story 1990s boom was a convergence story Convergence telescoped into one decade Convergence telescoped into one decade No single factor accounts for 1990s boom No single factor accounts for 1990s boom Why didn’t Ireland converge sooner? Why didn’t Ireland converge sooner? Institutional preconditions for such convergence already present in 1973, but fiscal policy errors in the 1970s derailed convergence Institutional preconditions for such convergence already present in 1973, but fiscal policy errors in the 1970s derailed convergence

15. Honohan and Walsh (2002) Why was convergence in the 1990s so rapid? Why was convergence in the 1990s so rapid? How do we explain the employment boom? How do we explain the employment boom?

16. Source: Honohan and Walsh (2002)

18. Fiscal Errors See Figure 3: Budgetary Aggregates See Figure 3: Budgetary Aggregates See Figure 4: Marginal and Average Income Tax Rates, 1979-2002 See Figure 4: Marginal and Average Income Tax Rates, 1979-2002

19. Unfavorable external conditions Table 2: External conditions in the 1980s UK GDP Growth % per annum US $ short interest rate % 1981-841.812.0 1986-894.17.6 Source: Honohan and Walsh (2002)

20. Blanchard (2002) Key factor behind boom: Wage moderation Key factor behind boom: Wage moderation Wage moderation = “wage growth below the rate consistent with technological progress.” Wage moderation = “wage growth below the rate consistent with technological progress.” Low wage growth  lower costs  higher profits  higher K and L Low wage growth  lower costs  higher profits  higher K and L

21. Blanchard (2002) Recall: Y = A F(K, L) = A K  L (1-  )  Marginal product of labour (MPL) MPL =  Y/  L = (1-  )A F(K, L)/L MPL =  Y/  L = (1-  )A F(K, L)/L  From micro, we know that firms choose L to equate the MPL to the market wage rate

22. So, for the whole economy: w = (1-  )A F(K, L)/L w/A = (1-  ) F(K, L)/L w/A = (1-  ) (K/L)  Exercise 4: Prove it! Exercise 4: Prove it! If w/A falls, then If w/A falls, then K/L must fall K/L must fall But K rises due to higher profits But K rises due to higher profits So L must boom! So L must boom!

25. So wage restraint boosts investment and especially employment Sources of wage restraint Sources of wage restraint Social partnership agreements Social partnership agreements High unemployment High unemployment Natural demographics Natural demographics Immigration Immigration Income tax cuts Income tax cuts

26. Why did wage moderation have such a large effect in Ireland? Why did wage moderation have such a large effect in Ireland? Openness of economy Openness of economy Notable amount of  K took the form of Foreign Direct Investment (FDI) Notable amount of  K took the form of Foreign Direct Investment (FDI) Migration flows Migration flows Available export markets Available export markets No “crowding out” No “crowding out”

27. Reading for next lecture Reading for next lecture Ahearne, Kydland, and Wynne (2005) Ahearne, Kydland, and Wynne (2005) Barry (2002) Barry (2002) Fitz Gerald (2004) Fitz Gerald (2004)