ch11 4e

Prepared by:
Fernando Quijano and Yvonn Quijano
2006 Prentice Hall Business Publishing
Macroeconomics, 4/e
CHAPTER 11
CHAPTER11
Saving, Capital
Accumulation,
and Output
Olivier
Chapter 11: Saving, Capital

Accumulation, and Output
Saving, Capital Accumulation,

and Output
The effects of the saving rate - the ratio of
saving to GDP on capital and output per capita
are the topics of this chapter.
An increase in the saving rate would lead to
higher growth for some time, and eventually to a
higher standard of living in the United States.
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11-1
Interactions Between
Output and Capital
At the center of the determination of output in the

long run are two relations between output and
capital:
The amount of capital determines the amount
of output being produced.
The amount of output determines the amount
of saving and investment, and so the amount
of capital being accumulated.
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Interactions Between
Output and Capital
Figure 11 - 1
Capital, Output, and
Saving/Investment
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The Effects of Capital on Output
Under constant returns to scale, we can write the

relation between output and capital per worker as
follows:
Yt
Kt
Kt
F
f
N
N ,1
N
In words: Higher capital per worker leads to
higher output per worker.
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Since the focus here is on the role of capital

accumulation, we make the following
assumptions:
The size of the population, the participation
rate, and the unemployment rate are all
constant.
There is no technological progress.
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Under these assumptions, the first important

relation we want to express is between output
and capital per worker:
Yt
K t
f
N
N
In words, higher capital per worker leads to
higher output per worker.
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The Effects of Output on

Capital Accumulation
We proceed in two steps:
First, we derive the relation between output
and investment.
Then, we derive the relation between
investment and capital accumulation.
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Output and Investment
We make three assumptions to derive the

relation between output and investment:
We assume the economy is closed.
I S (T G )
We assume public saving, T G, is equal to
zero.
I S
We assume that private saving is proportional

to income, so
S sY
Combining these two relations gives:
It sYt
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Investment and
The evolution of the capital stock is given by:
t1
(1 ) K t I t
denotes the rate of depreciation.

Combining the relation from output to investment,
It sYt
, and the relation from investment to

capital accumulation, we obtain the second
important relation we want to express, from
output to capital
K t 1 accumulation:
K t
Yt
(1 )
s
N
Macroeconomics, 4/e
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Investment and
Output and Capital per Worker:
K
t1
K t
Yt
(1 )
s
N
N
Rearranging terms in the equation above, we can

articulate the change in capital per worker over
time:
K
t1
K t
Yt
K t
s

N
N
N
In words, the change in the capital stock per

worker (left side) is equal to saving per worker
minus depreciation (right side).
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11-2
Implications of
Alternative Saving Rates
Our two main relations are:

Yt
K t
f
N
N
First relation:
Capital determines
output.
t1
K t
Yt
K t
s

N
N
N
Second relation:
Output determines
capital accumulation
Combining the two relations, we can study the

behavior of output and capital over time.
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Dynamics of Capital and Output
Yt
K
f t
N
N
t1
K t
Yt
K t
s

N
N
N
From our main relations above, we express

output per worker (Y/N) in terms of capital per
worker to derive the equation below:
K
t1
K t
N
change in capital from

year t to year t+1
K t
sf
investment
during
year t
K t
N
depreciation
during year t
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t1
K t
N
change in capital from

year t to year t+1
K t
sf
investment
during
year t
K t
N
depreciation
during year t
If investment per worker exceeds depreciation

per worker, the change in capital per worker is
positive: Capital per worker increases.
If investment per worker is less than depreciation
per worker, the change in capital per worker is
negative: Capital per worker decreases.
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Figure 11 - 2
Capital and Output
Dynamics
When capital and

output are low,
investment exceeds
depreciation, and
capital increases.
When capital and
output are high,
investment is less than
depreciation and
capital decreases.
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At K0/N, capital
per worker is
low, investment
exceeds
depreciation,
thus, capital per
worker and
output per
worker tend to
increase over
time.
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At K*/N, output
per worker and
capital per
worker remain
constant at their
long-run
equilibrium
levels.
Investment per worker increases with capital per worker, but
by less and less as capital per worker increases.
Depreciation per worker increases in proportion to capital
per worker.
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Steady-State Capital and Output

t1
K t
K t
K t
= sf

N
N
N
The state in which output per worker and capital

per worker are no longer changing is called the
steady state of the economy. In steady state,
the left side of the equation above equals zero,
then:
K *
K *
sf
Given the steady state of capital per worker

(K*/N), the steady-state value of output per
worker (Y*/N), is given by the production
function:
Y *
K *
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The Saving Rate and Output
Three observations about the effects of the

saving rate on the growth rate of output per
worker are:
1. The saving rate has no effect on the long run
growth rate of output per worker, which is
equal to zero.
Macroeconomics, 4/e
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worker are:
2. Nonetheless, the saving rate determines the
level of output per worker in the long run.
Other things equal, countries with a higher
saving rate will achieve higher output per
worker in the long run.
Macroeconomics, 4/e
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worker are:
3. An increase in the saving rate will lead to
higher growth of output per worker for some
time, but not forever. The saving rate does
not affect the long-run growth rate of output
per worker. After a higher saving rate, growth
will end once the economy reaches its new
steady state.
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Figure 11 - 3
The Effects of
Different Saving
Rates
A country with a higher

saving rate achieves a
higher steady-state
level of output per
worker.
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Figure 11 - 4
The Effects of an
Increase in the
Saving Rate on
Output per Worker
An increase in the
saving rate leads to a
period of higher
growth until output
reaches its new higher
steady-state level.
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Capital Accumulation and

Growth in France in the
Aftermath of WWII
Table 1
Proportion of the French Capital Stock Destroyed by the End of

World War II
Railways(%)
Tracks
Stations
38
Canal Locks
11
Engines
21
Barges
80
Hardware
60
Roads (%)
Cars
31
Trucks
40
Rivers (%) Waterways
Buildings
(numbers)
Dwellings
Industrial
86
1,229,000
246,000
When WWII ended in 1945, France had suffered

some of the heaviest losses of all European
countries. A vivid picture of the destruction of
capital is provided by the numbers in Table 1.
Macroeconomics, 4/e
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The Saving Rate and Consumption

Figure 11 - 5
The Effects of an
Increase in the
Saving Rate on
Output per Worker in
an Economy with
Technological
Progress
An increase in the
saving rate leads to a
period of higher
growth until output
reaches a new, higher
path.
Macroeconomics, 4/e
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The level of capital associated

with the value of the saving
rate that yields the highest
level of consumption in
steady state is known as the
golden-rule level of capital.
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Figure 11 - 6
The Effects of the
Saving Rate on
Consumption per
Worker in Steady
State
An increase in the
saving rate leads to an
increase, then to a
decrease, in
consumption per
worker in steady state.
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For s larger than sG,

increases in the
saving rate still lead
to higher capital and
output per worker, but
lower consumption
per worker.
For s=1, capital and
output per worker are
high, but all of the
output is used to
replace depreciation,
leaving nothing for
consumption.
Macroeconomics, 4/e
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Social Security, Savings, and

Capital Accumulation in the
United States
One way to run a social security system is the payas-you-go system, where the taxes that workers
pay are the benefits that current retirees receive.
Another is the fully-funded system, where
workers are taxed, their contributions invested in
financial assets, and when workers retire, they
receive the principal plus the interest payments on
their investments.
In anticipation of demographic changes, the Social
Security tax rate has been increases, and
contributions are now larger than benefits, leading
to the accumulation of a Social Security trust fund.
Macroeconomics, 4/e
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Getting a Sense
of the Magnitudes
11-3

Assume the production function is:

Y
Output per worker is:

N
N
N
N
Output per worker, as it relates to capital per worker
is:
K t
K t
f
Given our second relation,

Then,
t1
K t
s
N
t1
K t
K t
K t
= sf

N
N
N
K t
K t
N
N
Macroeconomics, 4/e
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The Effects of the Saving Rate on

Steady-State Output

t1
K t
s
N
K t
K t
N
N
K
K

N
N
In steady state, the left side equals zero, then:s

Squaring both sides, s 2
K
K

N
N
Dividing by (K/N) and rearranging,
K
s

N
In words, the steady state capital per worker is

equal to the square of the ratio of the saving rate
to the depreciation rate.
Output per worker is given by:
Macroeconomics, 4/e
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The Effects of the Saving Rate on

Steady-State Output
Steady-state output per worker is equal to the

ratio of the saving rate to the depreciation rate.
A higher saving rate and a lower depreciation
rate both lead to higher steady-state capital per
worker and higher steady-state output per
worker.
Macroeconomics, 4/e
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The Dynamic Effects of an

Increase in the Saving Rate

Figure 11 - 7
Dynamic Effects of
an Increase in the
Saving Rate from 10
to 20% on the Level
and the Growth Rate
of Output per Worker
It takes a long time for

output to adjust to its
new higher level after
an increase in the
saving rate. Put
another way, an
increase in the saving
rate leads to a long
period of higher
growth.
Macroeconomics, 4/e
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The U.S. Saving Rate

and the Golden Rule
In steady state, consumption per worker is equal
to output per worker minus depreciation per
worker.
C
Y
K
N
Knowing that:
then:
K
s

N
and
C
s
s

N
s 1 s
These equations are used to derive the Table 11-1

in the next slide.
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The U.S. Saving Rate

and the Golden Rule
Table 11-1
Saving Rate, s
The Saving Rate and the Steady-state Levels of Capital,

Output, and Consumption per Worker (=10%)
Capital per worker,
K/N
Output per
worker, Y/N
Consumption per
worker, C/N
0.0
0.0
Y
s
0.0
0.1
1.0
1.0
0.9
0.2
4.0
2.0
1.6
0.3
9.0
3.0
2.1
0.4
16.0
4.0
2.4
0.5
25.0
5.0
2.5
0.6
36.0
6.0
2.4
1.0
100.0
10.0
0.0
K
s

N
C
s 1 s
Macroeconomics, 4/e
0.0
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11-4
Physical Versus
Human Capital
The set of skills of the workers in the economy is

called human capital.
An economy with many highly skilled workers is
likely to be much more productive than an
economy in which most workers cannot read or
write.
The conclusions drawn about physical capital
accumulation remain valid after the introduction
of human capital in the analysis.
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Extending the Production Function
When the level of output per workers depends on

both the level of physical capital per worker, K/N,
and the level of human capital per worker, H/N,
the production function may be written as:
Y
K H
f
,
N N
N
( , )
An increase in capital per worker or the average

skill of workers leads to an increase in output per
worker.
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Extending the Production Function
A measure of human may be constructed as

follows:
Suppose an economy has 100 workers, half of
them unskilled and half of them skilled.
The relative wage of skilled workers is twice that
of unskilled workers. Then:
H
150
H [(5 0 1) (5 0 2 )] 1 5 0
1 .5
N
100
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Human Capital, Physical

Capital, and Output
An increase in how much society saves in the
form of human capitalthrough education and
on-the-job-trainingincreases steady-state
human capital per worker, which leads to an
increase in output per worker.
In the long run, output per worker depends not
only on how much society saves but also how
much it spends on education.
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Human Capital, Physical

Capital, and Output
In the United States, spending on education comprises
about 6.5% of GDP, compared to 16% investment in
physical capital. This comparison:
Accounts for the fact that education is partly
consumption.
Does not account for the opportunity cost of
education.
Does not account for the opportunity cost of on-thejob-training.
Considers gross, not net investment. Depreciation
of human capital is slower than that of physical
capital.
Macroeconomics, 4/e
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Endogenous Growth
A recent study has concluded that output per

worker depends roughly equally on the amount of
physical capital and the amount of human capital
in the economy.
Models that generate steady growth even without
technological progress are called models of
endogenous growth, where growth depends on
variables such as the saving rate and the rate of
spending on education.
Macroeconomics, 4/e
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Key Terms
saving rate
steady state
golden-rule level of capital
pay-as-you-go social security
system
fully-funded social security

system
social security trust fund
human capital
models of endogenous growth
Macroeconomics, 4/e
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Prepared by:

Fernando Quijano and Yvonn Quijano

2006 Prentice Hall Business Publishing

Chapter 11: Saving, Capital

Saving, Capital Accumulation,

2006 Prentice Hall Business Publishing

Chapter 11: Saving, Capital

At the center of the determination of output in the

2006 Prentice Hall Business Publishing

Chapter 11: Saving, Capital

2006 Prentice Hall Business Publishing

Chapter 11: Saving, Capital

The Effects of Capital on Output

Under constant returns to scale, we can write the

2006 Prentice Hall Business Publishing

Chapter 11: Saving, Capital

The Effects of Capital on Output

Since the focus here is on the role of capital

2006 Prentice Hall Business Publishing

Chapter 11: Saving, Capital

The Effects of Capital on Output

Under these assumptions, the first important

2006 Prentice Hall Business Publishing

Chapter 11: Saving, Capital

The Effects of Output on

2006 Prentice Hall Business Publishing

Chapter 11: Saving, Capital

Output and Investment

We make three assumptions to derive the

We assume that private saving is proportional

Combining these two relations gives:

2006 Prentice Hall Business Publishing

Chapter 11: Saving, Capital

denotes the rate of depreciation.

, and the relation from investment to

2006 Prentice Hall Business Publishing

Chapter 11: Saving, Capital

Rearranging terms in the equation above, we can

In words, the change in the capital stock per

2006 Prentice Hall Business Publishing

Chapter 11: Saving, Capital

Our two main relations are:

Combining the two relations, we can study the

2006 Prentice Hall Business Publishing

Chapter 11: Saving, Capital

Dynamics of Capital and Output

From our main relations above, we express

change in capital from

2006 Prentice Hall Business Publishing

Chapter 11: Saving, Capital

Dynamics of Capital and Output

change in capital from

If investment per worker exceeds depreciation

2006 Prentice Hall Business Publishing

Dynamics of Capital and Output

Chapter 11: Saving, Capital

When capital and

2006 Prentice Hall Business Publishing

Chapter 11: Saving, Capital

Dynamics of Capital and Output

2006 Prentice Hall Business Publishing

Chapter 11: Saving, Capital

Dynamics of Capital and Output