1. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley. 4-1 Chapter 4 Growth and Policy

2. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley. 4-2 Objectives Use Endogenous Growth theory to explain the influence of society’s choices on patterns of economic growth Examine the process by which some countries move from underdeveloped to developed economies Consider the problems of population growth Analyse the lessons of countries that have experienced rapid economic growth

3. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley. 4-3 Chapter Organisation 4.1Endogenous Growth Theory 4.2Growth Policy 4.3Lessons from Asia and Africa

4. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley. 4-4 4.1 Endogenous Growth Theory GDP and GDP growth are determined by the rates of: –Savings –Population growth –Technical progress. How do society’s choices affect these parameters?

5. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley. 4-5 Endogenous Growth Neoclassical growth theory: –Attributes long-run growth to technical progress –Does not explain the economic determinants of technical progress –also suggests that economic policy cannot affect long-run rates of growth. Dissatisfaction with the neoclassical growth model led to other growth theories being formulated. Consider Endogenous Growth theory.

6. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley. 4-6 The Mechanics of Endogenous Growth The development of other growth models either: –Explicitly include technological change in the model, or –Exhibit non-diminishing returns to capital. These models explain continuous growth without the need to assume an exogenous change in technological development.

7. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley. 4-7 The Mechanics of Endogenous Growth

8. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley. 4-8 The Mechanics of Endogenous Growth Consider the basic Solow growth model in Figure 4.1(a). The model predicts that: –Savings grow at a diminishing rate (sy) –Investment grows at the constant rate, ((n + d)k) –The economy will reach the steady state (C) –Where savings equals investment –Savings greater than investment implies growth.

9. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley. 4-9 The Mechanics of Endogenous Growth Because of diminishing marginal product of capital: –Production (y = f(k)) and savings (sy) must eventually flatten out. –Investment grows constantly. –Until savings is equal to investment in steady-state equilibrium.

10. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley. 4-10 The Mechanics of Endogenous Growth

11. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley. 4-11 The Mechanics of Endogenous Growth In Figure 4.1(b) the shape of the production function is altered to assume constant marginal product of capital. For constant marginal product of capital: –savings are always equal to investment –savings therefore cause economic growth. The growth rate of output is therefore: –dependent upon the savings rate –the constant marginal product of capital.

12. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley. 4-12 The Mechanics of Endogenous Growth The production function is now expressed as: Y = aK(4.1) Assuming that the rate of savings is constant and there is no population growth or depreciation of capital:  K = sY = saK or  K/K = sa(4.2) Following from this:  Y/Y= sa(4.3) This implies that the higher the savings rate, the higher the rate of growth in output.

13. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley. 4-13 Deeper Economics of Endogenous Growth Constant returns to capital implies that doubling capital doubles output. Hence, the doubling of all factors of production: –Will more than double output, or –There will be increasing returns to scales if all factors of production are included. This suggests larger firms are more efficient.

14. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley. 4-14 Deeper Economics of Endogenous Growth An implication of the assumption of constant returns to scale for capital is that it will encourage industry concentration. Monopolisation has not occurred across the economy because: –Private returns differ from social returns. –The firm is not able to ‘capture’ all the benefits of its capital stock. –There are positive externalities to increases in capital stock. –A firm’s increasing capital causes other firms’ productivity to increase.

15. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley. 4-15 Convergence Classical growth theory predicts conditional convergence, that is: –Countries which invest more grow faster. –This faster growth is transitory. –Higher savings and investment will end with higher per capita income in steady state. –The growth rate will not be higher.

16. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley. 4-16 Convergence In contrast, Endogenous Growth theory suggests that: –A high savings rate leads to a higher growth rate. –Countries do not converge conditionally. –We are more likely to observe countries diverging. Empirical evidence tends to support the argument that conditional convergence occurs. This suggests that endogenous growth theory might not be important in explaining the differences in growth rates between countries.

17. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley. 4-17 Chapter Organisation 4.1Endogenous Growth Theory 4.2Growth Policy 4.3Lessons from Asia and Africa

18. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley. 4-18 Growth Policy Neither the neoclassical growth model or the Endogenous Growth model explain why some countries experience no growth and others very high growth. One method of doing this is to combine the two models to form a two-sector model. Figure 4.2 illustrates the two-sector model.

19. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley. 4-19 Growth Policy

20. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley. 4-20 Growth Policy In Figure 4.2 the neoclassical steady-state model can be seen at point A. At low income and capital point A represents a no-growth steady state. The economy at this point is caught in a growth trap. At high income and capital beyond point B the savings line is above the capital requirement line, leading to continuing increases in the rate of growth.

21. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley. 4-21 Population Growth and Growth Traps Growth theories suggest that living standards decrease when population growth increases. The Solow growth model predicts that: –High population growth reduces the steady-state income. –Each worker will have less capital to work with.

22. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley. 4-22 Population Growth and Growth Traps The Solow model predicts that high population growth leads to a lower steady-state income. Adapting the Solow model to indicate endogenous population growth points to the existence of a poverty trap. The slope of the investment requirement line changes as population growth is not longer assumed to be constant. Figure 4.3 illustrates this adjustment and the poverty trap.

23. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley. 4-23 Population Growth and Growth Traps

24. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley. 4-24 Population Growth and Growth Traps The investment requirement line with variable population growth now: –Rises slowly (due to the moderate population growth when income is very low) –Then increases sharply (due to the increase in population growth when income rises) –Before eventually flattening out (as population growth drops again due to high incomes) –Point A on the diagram represents the poverty trap. At this point, population growth is high and income low.

25. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley. 4-25 Natural Resources: Limits to Growth? Will exponential growth in the economy eventually lead to the complete depletion of the fixed stock of resources? No. Why? The economy is protected from resource depletion disasters by two factors: –Technical progress permits us to produce more using fewer resources. –As resource supply lessens, prices rise, leading producers to shift towards substitutes.

26. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley. 4-26 Social Infrastructure Why do some countries have more capital than others? Why do some countries save and invest more than others? The answers to these questions lie partly in the provision of social infrastructure. Social infrastructure is the institutions and policies that encourage and protect the individual and provide the framework in which economic decisions are made.

27. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley. 4-27 Chapter Organisation 4.1Endogenous Growth Theory 4.2Growth Policy 4.3Lessons from Asia and Africa

28. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley. 4-28 4.3 Lessons from the Asian Tigers Hong Kong, Singapore, South Korea and Taiwan have grown rapidly for two decades. What were the reasons for this? Studies indicate that high growth rates were explained by increased input not higher productivity.

29. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley. 4-29 Lessons from the Asian Tigers Characteristics of the growth experience in these countries have been: –Increased human capital –Encouraged labour force participation, and –Concentrated on education.

30. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley. 4-30 Lessons from Africa In contrast to the Asian Tigers, sub Saharan Africa has experienced ‘growth disasters’. Why? Low savings rates and high population growth partly explain why sub Saharan countries have failed to grow. ‘Destiny factors’ determined by geographic and climatic conditions have also contributed to low growth rates. Socio-political factors such as unstable political conditions and lack of social infrastructure are also important considerations.

31. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz Slides prepared by Dr Monica Keneley. 4-31 Lessons from Africa Models of savings and population growth can partly explain why sub Saharan African countries have failed to grow. The experiences of these countries point to the need to consider the policy environments which are conducive to economic growth.