MA Macroeconomics

10. Growth Accounting

Karl Whelan

School of Economics, UCD

Autumn 2014

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Growth Accounting
The final part of this course will focus on “growth theory.”
This branch of macroeconomics concerns itself with what happens over long
periods of time.
We will discuss the factors that determine the growth rate of the economy
over the long run and what can policy measures do to affect it.
This is closely related to the crucial question of what makes some countries
rich and others poor.
We will begin by covering “growth accounting” – a technique for explaining
the factors that determine growth.

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Production Functions
We assume output is determined by an aggregate production function
technology depending on the total amount of labour and capital.
For example, consider the Cobb-Douglas production function:

Yt = At Ktα Lβt

where Kt is capital input and Lt is labour input.

An increase in At results in higher output without having to raise inputs.
Macroeconomists usually call increases in At “technological progress” and
often refer to this as the “technology” term.
At is simply a measure of productive efficiency and it may go up or down for
all sorts of reasons, e.g. with the imposition or elimination of government
regulations.
Because an increase in At increases the productiveness of the other factors, it
is also sometimes known as Total Factor Productivity (TFP).

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Productivity Growth
Output per worker is often labelled productivity by economists with increases
in output per worker called productivity growth.
Productivity with Cobb-Douglas is
 α
Yt Kt
= At Ktα Lβ−1
t = At Lα+β−1
t
Lt Lt

There are three potential ways to increase productivity:

1 Technological progress: Improving the efficiency with which an economy
uses its inputs, i.e. increases in At .
2 Capital deepening (i.e. increases in capital per worker)
3 Increases in the number of workers:
F Only adds to growth if α + β > 1, i.e. increasing returns to scale.
F Most growth theories assume constant returns to scale: A doubling of
inputs produces a doubling of outputs. Under CRS, α + β − 1 = 0 and
productivity is  α
Yt Kt
= At
Lt Lt

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Determinants of Growth
Let’s consider what determines growth with a constant returns to scale
Cobb-Douglas production function (so β = 1 − α)

Yt = At Ktα L1−α
t

ans assume that time is continuous: t evolves smoothly instead of just taking
integer values like t = 1 and t = 2.
Denote the growth rate of Yt by GtY . This can be defined as
1 dYt
GtY =
Yt dt

Can characterise as a function of GtY the growth rates of labour, capital and
technology by differentiating production function with respect to time.
Recall product rule of differentiation implies
dABC dA dB dC
= BC + AC + AB
dx dx dx dx

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The Key Equation of Growth Accounting
In our case, we have
dYt dAt Ktα Lt1−α
=
dt dt
α 1−α
dAt 1−α dKt α dLt
= Ktα L1−α
t + At L t + At K t
dt dt dt
α 1−α dAt α−1 1−α dKt dLt
= K t Lt + αAt Kt Lt + (1 − α) At Ktα L−α
t
dt dt dt
Dividing across by At Ktα L1−α
t , this becomes
GtY = GtA + αGtK + (1 − α) GtL
The growth rate of output equals the growth rate of the technology term plus
a weighted average of capital growth and labour growth, where the weight is
determined by the parameter α.
This is the key equation in growth accounting studies. These studies provide
estimates of how much GDP growth over a certain period comes from growth
in the number of workers, how much comes from growth in the stock of
capital and how much comes from improvements in TFP.
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How to Calculate the Sources of Growth: Solow (1957)

For most economies, we can calculate GDP, number of workers and get some
estimate of the stock of capital. We don’t directly observe the value of the
Total Factor Productivity term, At .
However, if we knew the value of the parameter α, we could figure out the
growth rate of TFP:

GtA = GtY − αGtK − (1 − α) GtL

In a famous 1957 paper, Robert Solow pointed out that we could arrive at an
estimate of α by looking at the shares of GDP paid to workers and to capital.

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Solow (1957) Continued
Consider the case of a perfectly competitive firm that is seeking to maximise
profits.
Suppose the firm sells its product for a price Pt , pays wages of Wt and rents
its capital for a rate of Rt .
This firm’s profits are given by
Πt = Pt Yt − Rt Kt − Wt Lt
= Pt At Ktα L1−α
t − Rt Kt − Wt Lt

Now consider how the firm chooses how much capital and labour to use. It
will maximise profits by differentiating the profit function with respect to
capital and labour and setting the resulting derivatives equal to zero. This
gives two conditions
∂Πt
= αPt At Ktα−1 L1−α
t − Rt = 0
∂Kt
∂Πt
= (1 − α) Pt At Ktα L−α
t − Wt = 0
∂Lt

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Estimating α
These can be simplified to read
∂Πt Pt Yt
= α − Rt = 0
∂Kt Kt
∂Πt Pt Yt
= (1 − α) − Wt = 0
∂Lt Lt
Solving these we get
Rt Kt
α =
Pt Yt
Wt Lt
1−α =
Pt Yt
Pt Yt is total nominal GDP.
Wt Lt is the total amount of income paid out as wages.
Rt Kt is the total amount of income paid to capital.
These equations tell us that we can calculate 1 − α as the fraction of income
paid to workers rather than to compensate capital.
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Solow’s Findings
In most countries, national income accounts show that wage income accounts
for most of GDP, meaning α < 0.5.
A standard value that gets used in many studies, based on US estimates, is
α = 13 .
However, note that some studies do this calculation assuming firms are
imperfectly competitive – if this is the case, then the shares of income earned
by labour and capital depend on the degree of monopoly power.
Solow’s 1957 paper concluded that capital deepening had not been that
important for U.S. growth.
In fact, he calculated that TFP growth accounted for 87.5% of growth in
output per worker over that period.
TFP is sometimes called “the Solow residual” because it is a “backed out”
calculation that makes things add up.

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BLS Multifactor Productivity Figures
Most growth accounting calculations are done as part of academic studies.
However, in some countries the official statistical agencies produce growth
accounting calculations.
In the U.S. the Bureau of Labor Statistics (BLS) produces them under the
name “multifactor productivity” calculations.
The BLS add some additional factors, for example account for improvements
in the “quality” of the labour force (educational qualifications and work
experience of employees). In other words, they view the production function
as being of the form
1−α
Yt = At Ktα (qt Lt )

where qt is a measure of the “quality” of the labor input.

The next slide shows a summary of the BLS’s calculations of the sources of
growth in the US from 1987 to 2013.

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Growth Accounting Calculations for the U.S.

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Weakening Prospects for Long-Run US Growth?
The BLS calculations show US productivity growth is weakening.
Another factor that is weighing on the potential for output growth is a slow
growth rate of the labour force.
After years of increasing numbers of people available for work due to normal
population growth, immigration and increased female labour participation, the
US labour force has flattened out.
This is being driven by long-run demographic trends as the large “‘baby
boom” generation starts to retire.
This trend is set to continue over the next few decades.
The dependency ratio (the ratio of non-working to working people) is
projected to increase significantly as the populations grows older on average.

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The U.S. Labour Force

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The Ratio of Non-Working to Working People in U.S.

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Growth Accounting for the Euro Area

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Demographic Projections for the Euro Area

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Example: A Tale of Two Cities
Alwyn Young’s 1992 paper “A Tale of Two Cities: Factor Accumulation and
Technical Change in Hong Kong and Singapore” is an interesting example of a
growth accounting study.
Both economies were successful: Hong Kong had total growth of 147%
between the early 1970s and 1990 and Singapore had growth of 154%.
But Young was interested in exploring the extent to which TFP contributed to
growth in these two economies.
He found that Singapore’s approach (capital deepening and forced saving) did
not produce any TFP growth while Hong Kong’s more free market approach
lead to strong TFP growth.
Hong Kong achieved the growth without having to divert a huge part of
national income towards investment rather than consumption.
As we will see in the next lecture, TFP-based growth has another advantage
over growth based on capital accumulation because it is more sustainable.

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Table from Alwyn Young’s 1992 Paper

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Things to Understand from this Topic
The sources of growth in output per worker.
How to derive the growth rate of output under constant returns as a function
of the growth rates of capital, labour and TFP.
Solow’s method for calculating TFP growth.
Evidence from the BLS on US productivity growth.
Evidence on growth in Europe.
Young’s Tale of Two Cities.

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