Course:

Economics II (macroeconomics)

Chapter 7
7.1 Long Run Economic Growth, Part I.

Author: Ing. Vendula Hynková, Ph.D.

Introduction

The aim of this chapter is to analyze and explain key determinants of long-term
economic growth (potential GDP growth) and the possibility of activating them as a
prerequisite for improving the standard of living and creating economic conditions for
strengthening the country's defense.

We will focus here on identifying the main determinants of potential output growth in
the long run. We will explain the basic categories by which we can analyze the
neoclassical production function and long-term economic growth model, developed
by Robert M. Solow. In the second part of this lecture we will analyze the Solow
model that characterizes stable (permanent) state and relationships between
savings, capital accumulation and economic growth.

1 Production function and the neoclassical model of long-term economic

growth

Basic concepts and relationships

The productive resources of the economy are the following:

1) the factors of production (inputs) – labor and capital: growth in the volume
(quantity) inputs directly affects the growth of production.

2) level of technology – raising the level of technology used leads to the growth of
the product for a given (fixed) amount of inputs.

Used level (state) technology is reflected in the growth of total (integral) productivity
of factor inputs, respectively so called “multifactor productivity”.

Aggregate production function (general form) - describes the relationship between

potential output (Y*) and factor inputs used in its manufacture - capital (K), labor (N)
and level of the technology (κ).

The aggregate production function is transformed in a given period factor inputs to a

maximum achievable potential output - shows "creating" the maximum capacity of the
economy, which in the long run fully used, i.e. the real unemployment rate is equal to
the natural rate of unemployment and capital is fully utilized.

A special form of the production function: Y* = κ F (K, N), where

κ = summary (integral) factor productivity, respectively multifactor productivity and

F (K, N) = standard neoclassical production function

Average productivity per worker = product or production per hour worked, or briefly
the production per unit of work output: Q = Y*/N (provided that the actual product is
equal to the potential product).
Returns to scale (assuming that the level of technology does not change):

I. constant returns to scale = increase the range, i.e. the amount or size of the
process used in the production of capital and labor, results in an increase in
production at the same rate;

II. increasing returns to scale = output is growing faster than the growing volume
of used capital and labor;

III. decreasing returns to scale = production is growing more slowly than the
growing volume of used capital and labor.

Capital intensity means the average volume of equity attributable to the use of one
employee, respectively unit of work (coefficient of capital intensity: ν = K/N

Intensive production function is: q = f κ (ν)

Intensive production function establishes the possibility of substitution between

capital and labor, because each point of this function is the ratio of average labor
productivity (q) and capital intensity (ν).

Increase in technological progress shifts the production function upwards. The

analysis shows that the average productivity can be increased:

- increasing capital intensity, i.e. moving through the intensive production

function;

- increasing the level of technology used, i. e. from the "lower" intensive

production function to a "higher" intensive production function or shift intensive
production function upward;

- as a result of growth of the capital intensity, and consequently increasing the

level of the technology used, i.e. introduction of technological progress.

b) Rate of output growth and basic equation of growth accounting

Theoretical framework of growth accounting, under which the rate of growth

analyzed, was developed by Robert M. Solow. Its growth model is based on standard
neoclassical assumptions:

1) In economics, there is perfect competition in both the labor market and the capital
market, firms maximize profits and wages are perfectly flexible. Therefore, in the long
run marginal product of labor determines the real wage and the marginal product of
capital determines the rate of profit on capital.

2) There is a perfect substitution between capital goods and consumer goods.

3) There are constant returns to scale.

4) The coefficient of labor participation is invariant, i.e., that population growth is
consistent with the growth rate of labor (labor input).

5) It is a closed economy here.

The starting point for determining the determinant tempo (rate) growth (potential)
product (retired) as key performance characteristics of the economy is the general
form of the aggregate production function and the assumption of neutral
technological progress (a special form, resp. Type) that increase the level of
technology used in the same way increases the marginal product of capital and the
marginal product of labor.

The basic equation of growth accounting: y * = ψ + w. k + (1 - w). n

The equation shows that the potential growth rate is equal to the sum of:

i) the rate, respectively aggregate growth rate (integral) factor productivity (ψ);

ii) the pace, respectively the growth rate of capital (k) multiplied by (weighted) share
the cost of capital for the product (w);

iii) the pace, respectively growth rate of labor input (n) multiplied by (weighted) share
of labor costs on the product (1 - w).

The coefficient ψ in the literature called residual member or also as a Solow residue,
and because of its direct measurability is difficult and practically determined
indirectly: ψ = y * - w. k - (1 - w). n

Summary (integral) productivity or multifactor productivity grows when it gets higher

(measurable) product from the same amount (volume) of production factors capital
and labor. This means that grows mainly due to the utilization of research and
development, improved technology, increased education and qualifications,
experience and professional training, due to the use of improved methods of work
organization and management, etc.

In the world literature, there is a more general concept of comprehensive (integral)

factor productivity.

2 Solow model of long-term economic growth

Model characterizes stable (permanent) status, relationships between savings,

capital accumulation and economic growth. Settled by savings shape resources,
which are then used for capital formation (capital accumulation), which in turn leads
to higher economic growth and improving living standards.

Stable (steady) state of the economy is a situation of long-term steady economic

growth.

a) Savings and basic equation of capital accumulation

The starting point of the analysis of this problem is the equality of total gross
domestic investment (I) and gross domestic savings (S).

Furthermore, the increase in capital will be equal investments (savings made by

forming a fixed proportion of the potential product) reduced by amortization (wear).

Population growth and the growth rate of the labor force are identical and are
growing at a constant rate, which is determined by factors outside the model, i.e.
exogenously.

The basic equation of capital accumulation: ∆ν = s. q - (n + d). ν

With regard to the above equation, we can specify the characteristics of stable
(permanent) state:

Stable (steady) state = a situation where capital intensity (capital per worker) reaches
equilibrium values, its level remains unchanged, that is capital grows at the same rate
as the labor force.

Prerequisite for the achievement of this situation is that the savings per capita is just
equal to the savings on expansion capital and savings used to compensate for worn-
out capital, i.e. ∆ν = 0 and that relationship will shape: s. q = (n + d). ν

Stable (steady) state:

The growth rate of capital = potential GDP growth rate = growth rate of population

Regardless of baseline level of capital intensity (facilities), growing economy

converges to a stable (steady) state as a state of long-run equilibrium growth, which,
under certain preconditions equal to population growth.

In a stable (steady) state the level of labor productivity per capita (product per unit of
labor input) does not change.
Fig. 7.1.1 The Solow model – stable state of the economy

Once the economy reaches stable (permanent) steady growth of the economy have
the same potential growth rate regardless of the amount of their propensity to save
and accumulate capital (the impact of the law of diminishing returns from capital to
labor productivity decline in average), see Fig. 7.1.1.

Increase in national savings rate:

i. it leads to an increase in the growth rate of potential output over population growth
and long-term permanently increase the level of average labor productivity (and
hence living standards) and also increases the coefficient of capital intensity
(facilities);

ii. however, in the new stable state (at a higher savings rate), the rate of growth of
potential output equals the growth rate of the labor force and this means that the
growth rate of labor productivity in the new stable (still) does not change the state of
the economy.

b) Optimum growth and the golden rule of capital accumulation

We have set equality of investment and savings. Problem savings is but one of the
parties consumption behavior of households, because if you increase the savings
rate, thus reducing the rate of consumption. This creates a problem of choice: it is
better to save more in the presence or maximize the present consumption of the
population regardless of future growth? The answer to this concept provides optimal
growth of potential output.
Optimum growth of potential GDP growth rate is such that compensates victims
endured population that, on the one hand, in the present period of more dispute
arise, and the cost of capital accumulation and benefits (benefit) in the form of an
increase in consumer standard in the future on the other.

Stable (steady) state with the highest per capita consumption is called the golden rule
level of capital accumulation, respectively the golden rule of capital accumulation. Its
algebraic expression is: MPK = n + d.

According to the golden rule of capital accumulation in stable (steady) state

consumption is maximized when the per capita consumption marginal product of
capital (MPK) is equal to the growth rate of the labor force (n) and the wear rate of
capital (d).

c) long-term economic growth expanded by technological progress

Now leave the premise constant level technology used and we will consider
increasing the (changing) the level of technology used, respectively introduction of
technological progress as the main source of economic growth. The starting point
remains the model by R. M. Solow, who worked primarily with technological progress.

From the analysis of long-term economic growth (and its modeling using tools
implemented Solow) concluded that:

- technological progress (implemented technological change) is a critical factor

in growth of average labor productivity and thus a decisive factor for growth in
living standards;

- capital accumulation is in the process of growth of average labor productivity

less significant role;

In a stable state the capital ratio remains constant.

If the economy is experiencing the technological progress expansion work, then the
capital intensity ratio will increase even if the economy is in stable (steady) state of
growth (see Fig. 7.1.2).
Fig. 7.1.2 Technological progress – expanding the labor and neutral technological progress

Summary for this chapter:

1) Long-term equilibrium rate of growth of potential output in a stable (steady) state

equals the sum of the growth rate of technological progress expanding job and
population growth;

2) In a stable (steady) state are output to work effectively, respectively workers and
capital to work effectively, respectively worker unchanged, i.e. the growth rate is 0 %.

3) Capital intensity is increasing growth rate (ψ), i.e. the growth rate of technological
change;

4) In a stable (steady) state increasing production per capita, respectively average

labor productivity at a rate equal to the rate (rate) growth of technological progress.
Technological progress is the reason that production per capita is still growing. Solow
model thus shows that the only source of technological progress is constantly
increasing standard of living.
References and further reading:

MACH, M. Macroeconomics II for Engineering (Master) study, 1st and 2nd part.
Slany: Melandrium 2001. ISBN 80-86175-18-9.

ŠTANCL, et al. Fundamentals of the theory of military-economic analysis. 1st ed.

Brno: Monika Promotion, 2012. ISBN: 978-80-905384-0-5.

MAITAH, M. Macroeconomics in practice. 1st ed. Praha: Wolters Kluwer CR, 2010.
ISBN 978-80-7375-560-1

WAWROSZ, P., HEISSLER, H., MACH, P. Facts in macroeconomics - professional

texts, media reflection, practical analysis. Prague: Wolters Kluwer ČR, 2012. ISBN
978-80-7275-848-0.

OLEJNÍČEK, A. et al. Economic management in the ACR. 1st ed. Uherské Hradiště:
LV. Print, 2012. ISBN 978-80-260-3277-9.

ROMER, D. Advanced Macroeconomics. 3rd edition. New York: McGraw-Hill/Irwin,

2006. 678 p. ISBN 978-0-07-287730-4.