MACROECONOMICS II

GROWTH ACCOUNTING
INTRODUCTION
 We examine the determinants of economic growth
𝑮𝑫𝑷𝒕 − 𝑮𝑫𝑷𝒕 − 𝟏
𝑹𝑬𝑨𝑳 𝑮𝑫𝑷 𝑮𝑹𝑶𝑾𝑻𝑯 𝑹𝑨𝑻𝑬 = ∗ 𝟏𝟎𝟎
𝑮𝑫𝑷𝒕 − 𝟏
 In terms of the AD-AS framework sustained economic growth in GDP implies that the
structural equilibrium output level continually shifts to the right at a sustained rate of
growth.
 Growth theory focuses exclusively on the supply side of the economy—the expansion of
the productive potential in the very long term and the adjustment of the economy towards
that potential growth path.
 Aggregate Production Function: Captures the relationship between Aggregate Output (Y),
and the quantities of Labor (N), Capital (K) and Technology (A)
 Technological Advance (A) includes such attributes as: progress with regards to social
and economic institutions and practices that impact the productive potential of the
economy—such as property rights, constitutional framework, company law framework,
labor law, competition policy and policy etc), entrepreneurial and managerial skills and
organizational forms.
 We also examine the role of Human Capital (H), the skills and education endowments of
the Labor Force (N) which determines level of productivity.
 Not all factors of production can necessarily contribute to economic growth in the long
term in the same or with the same forcefulness—some are more potent than others and
some are more constrained than others.
 Not all long term growth paths are equally accessible for an economy, some growth paths
can suffer from imbalances and run into constraints
 Policymakers can improve the conditions and prospects for balanced growth If they are
all informed and can implement a few appropriate changes in economic behavior and
parameters in a country.
THE SOLOW GROWTH MODEL
𝒀 = 𝑓 𝐍; 𝐊; 𝐇; 𝐀
 This is the original proposed Production Function by Robert Solow, and assumes
Constant Returns to Scale
 Constant returns means that if each of the factors of production is increased
by a given percentage say 5%, output will also rise by 5%.
 Diminishing marginal returns to both labor and capital: If only one production
factor say labor, is repeatedly increased by a particular percentage say 10%,
while the other factors remain constant, total production Y will successively
increase not by the same percentage (10%), but by a shrinking percentage.
 The curvature of the Total Production function shows diminishing marginal
returns
 With Technological Advance (A), we assume non-diminishing marginal
returns—New technological or institutional innovations and refinements that add
proportionally (or more) to output growth always appear to be possible.
 We will assume constant returns to A: an increase in A always leads to the same
proportional increase (ie growth) in Y: If A increases by 5%, it will cause a 5%
increase in Y.
 Sustained increases in Y must come from either of two sources (or both): a sustained
move along TP due to increasing N, or a sustained upward shift or rotation of the TP
due to increased K, or improved technology and social and economic institutions A.
 Increases in K and A will increase labor productivity
 Sustained increases in Y (real GDP) and thus economic growth in the very long run will
depend positively on Investment (capital formation, infrastructure, machinery,
equipment etc), labor force growth and progress in terms of new technology and the
development of social and economic institutions and processes.
 Constrains on growth
 Labour force growth is constrained by natural limits on population growth rate—
increasing employment N is subject to diminishing marginal returns, so increasing
N out of line with K is less productive in the Long run.
 Capital expansion (K) is subject to diminishing marginal returns (if it is increased
out of line with labour (N)—skills mismatch)
 Capital formation (investment) has to be financed from aggregate saving—which
depends in turn on Y (and the saving rate)—The capital stock in turn does not
remain constant, it is subject to depreciation (wear and tear that occurs due to use
or machinery becoming obsolete and having to be replaced regularly through
investment)
 Regarding A: with growth due to improving technology and institutions not being
subject to diminishing returns, a given percentage growth in technology and
institutions (as measured by growth in A) leads to the same percentage growth in Y.
COBB DOUGLAS PRODUCTION FUNCTION

α 1−α
𝑌𝑡 = 𝐴𝑡𝐾𝑡 𝑁𝑡
 The parameters α and (1- α) represent the share of Capital (K) and Labour (N)
in income (Y).
Δ𝑌 Δ𝑁 Δ𝐾 Δ𝐴
= 1−α + α +
𝑌 𝑁 𝐾 𝐴

SOURCES OF SUSTAINED GROWTH

 Sustained increases in per capital growth (Y/N).
 Growing labour force and employment: sustained growth in the labour force and
employment can cause growth in aggregate output and income Y, but income
will grow slower than N (being choked by diminishing marginal returns) and
leads to a decline in (Y/N)
 Average material standards of living will decline, so N alone cannot
produce sustained growth in Y or (Y/N).
 Growing Capital Stock: Growth in capital stock K (with constant N) will lead to
growth in aggregate output and income Y—since the labour force remains
constant, (Y/N)—output per worker will increase suggesting that income per
capita grows correspondingly
 Production point moves graphically along the TP curve
 Sustained growth in capital alone will not bring about sustained growth in per capita
income (Y/N).
 Expanding Human Capital (H)
 Increasing (H/N), the level of human capital per person will increase aggregate
output and output per worker.
 Capital-dependent human capital is likely to be subject to diminishing marginal
returns. Thus (Y/N) increases less than the increase in (Hk/N).
 Technology-type human capital growth (HA) does not have diminishing marginal
returns—thus such growth in HA on can contribute to sustained positive growth in
(Y/N).

 Economic growth in the long run will remain positive as long as per capital growth
rate of income (Δy/y) is greater than growth rate of the population (Δn/n).
 The capital ratio (ΔK/K) will be greater as long as the rate of saving (and investment)
sY is greater than the rate of Depreciation of Capital (d)
 If sY=d, then all new investment is just sufficient to maintain the current levels
of physical capita, and K does not change, and income growth remains constant.
 Technical progress (ΔA/A) increases long run living standards, since the economy
becomes more productive at turning inputs (N, L, K, E) into output (real GDP).
 CONDITIONAL CONVERGENCE: WHEN TWO COUNTRIES HAVE SIMILAR
CHARACTERISTICS (similar technology, similar savings rate) BUT ONE
HAPPENS TO BE POORER THAN THE OTHER, THAT POORER COUNTRY
TENDS TO GROW FASTER THAN THE RICHER COUNTRY IE IT CATCHES
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