Tuesday’s (2/12) Class

Today we covered applications of the Solow Growth Model, and how it is used to explain:

  1. American economic growth and;
  2. World economic growth.

1. American Economic Growth

Real GDP per Capita: 1790-2006
Real GDP per capita in year 2000 dollars from 1790 to 2006

For American economic growth, we saw three broad periods in which productivity growth was either high or low. a. From 1800-1973, growth was high; b. From 1973-1995, growth was low; c. And from 1995 to the present growth has been fairly high by historical standards.

1a. 1800-1973
The first half of this period saw growth primarily due to growth in infrastructure (railways, steel mills, etc.), which translates to a higher capital-output ratio (or a higher capital intensity). But as you remember, from the Solow Growth Model, growth in capital-intensity is good, but it will only take us closer to our equilibrium path, or put us on the steady-state path. To actually increase productivity we must increase labor efficiency. Up until about 1929, growth in GDP per capita came from increases in the capital intensity, but post-1929, growth has come from increases in labor efficiency. This not only included technological advances like mass production by Ford, but also improvements in the organization of corporations.

1b. 1973-1995
Post-1973 saw a productivity slowdown which has yet to be explained by economists. While there are many theories floating around, there is no consensus on any one. Some of these include problems with GDP accounting and including environmental externalities into the GDP; increases in oil prices around that time; entrance of the baby boom generation into the workforce. However, with the first – even large estimation of the errors cannot explain away all of the slowdown. The increase in oil prices by OPEC is not a good explanation because although it happened almost simultaneously with the slowdown, the costs of oil to businesses as a percent of total costs is too low to explain away the growth. Finally, the entrance of the baby boom generation into the workforce is about their lack of experience contributing to a slowdown in growth. However, they also had a higher level of education than the previous generation, so that does not seem plausible. The bottomline? The slowdown is still a mystery. Some of the effects of the slowdown can still be felt in the increased income inequality from the mid-’70s.

Income Inequality Since the
Increased income inequality since the mid-1970s

1c. 1995-present
This period has seen a turnaround in productivity and has seen large growth rates of GDP per capita. The explanation for this lies in increased investment from 1992 up to the present (almost three times as large as growth rate of GDP), and falling prices of computers. This, coupled with the fact that businesses are now moving away from industrial capital towards information capital has really led to an increased output per worker.

Investment Increase + Computer Prices Fall
Increased investment levels coupled with a fall in the price of information capital.

2. The World Economy

World Economic Growth Through Deep Time
Economic growth of some Western European countries (and Australia) from 1 A.D. up to 2001 A.D.

Growth in the Western European countries didn’t really start until the 1800s because that is when the Industrial revolution took place. This, in turn, was caused by the establishment of stable government, secure financial markets and the proliferation of philosophical societies which spread scientific thought. All of this led to some remarkable innovation in that time including the invention of the blast furnace, the spinning jenny and lots, lots more.

Picture Source
The Industrial Revolution
The Industrial Revolution

Fast-forwarding to the present, while the United States still has a large economic share of the world pie, there has been some convergence by other economies toward closing the gap. The OECD economies are good examples – they benefited from the Marshall Plan. The East Asian economies have also shown growth rates that are closing the gap.

World Share of GDP
World share of GDP by various countries. East Asia as a whole is catching up with the US. China is also growing, but presently only takes up ~5% of world share of GDP.

We find that those countries that adopted the economic conditions enforced by the Marshall Plan are the ones that have shown the most growth in the last half-century, since World War II. Those conditions (in brief) are:

  1. The existence of large private sectors and little or no government interference;
  2. Investment following profit, and no other externally imposed rules;
  3. Good social insurance programs;
  4. Government takes measures to avoid mass unemployment.

Essentially, these are the conditions that have existed in the OECD economies since the Marshall Plan aid was given to them. As it turns out countries like Argentina and Venezuela which were quite wealthy at the time have not observed the above conditions and are now not faring all that well. Furthermore, it has been seen that ex-communist countries have paid a heavy price with around 40-94% of their economic values annihilated, depending on where they are, and how you count.

The Bottomline
Countries that have a high capital-output ratio have a high output-per-worker. The other important factor in economic growth has been shown to be schooling. While there is a direct relationship between investment and growth, there is a very strong correlation between years of schooling and the share of world GDP. Schooling improves labor efficiency, increasing the ease of adaptation of new technologies, as well as providing a fertile environment for innovation. Furthermore, governmental policies which encourage economic openness (free markets, open international trade) and secure intellectual property protection, are the ones that will bear the fruits of strong economic growth.

Data Sources Used

  • American Real GDP per Capita: Lawrence H. Officer and Samuel H. Williamson, “Annualized Growth Rate of Various Historical Economic Series” MeasuringWorth.Com, August 2006.
  • Increased Income Inequality: Macroeconomics (2e), Brad Delong and Martha Olney, 2006. Publisher: McGraw-Hill.
  • Economic Growth of Western Countries: Angus Maddison’s “World Population, GDP and Per Capita GDP, 1-2003 AD“ at The Groningen Growth and Development Centre (http://ggdc.net).
  • World Share of GDP: United States Department of Agriculture (http://usda.gov).
  • Falling Computer Prices: Bureau of Economic Analysis (http://bea.gov).
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