Why are we here?

The planet Earth in the darkness of the night*

* Image source: NASA (http://antwrp.gsfc.nasa.gov/apod/ap001127.html)

Measuring the state of economic development

Economic Development = Quality of Life

Life has multiple dimensions• Development Diamond

– Life expectancy at birth

– Gross primary (secondary) education enrollment

– Access to safe water

– GNP per capita

Life expetance at birth 2003

Physicians per 1000 people, 2001

Health care expenditures per

capita (current USD) 2002

% of population with improved water access

2002

Mexico 73.64 1.71 379.00 91.00Canada 79.34 2.10 2222.00 100.00United States 77.41 5274.00 100.00

France 79.26 3.29 2348.00 100.00Germany 78.33 3.62 2631.00 100.00Italy 79.83 6.07 1737.00 100.00United Kingdom 77.63 2031.00 100.00

Ukraine 68.29 2.97 40.00 98.00Russian Federation 65.71 4.17 150.00 96.00Belarus 68.17 4.50 93.00 100.00

Kenya 45.41 19.00 62.00Nigeria 44.91 19.00 60.00Tanzania 42.67 13.00 73.00Zimbabwe 38.53 118.00 83.00

Electric power consumption

(KWH per capita) 2002

Internet users per 1000 people 2002

Television sets per 1000 people 2001

Mexico 1659.70 98.48 281.96Canada 15613.00 512.83 690.63United States 12183.00 551.38 937.51

France 6606.40 313.83 631.92Germany 6046.00 436.17 637.41Italy 4901.20 352.44United Kingdom 5618.00 423.10 950.48

Ukraine 2229.20 18.75Russian Federation 4291.20Belarus 2656.60 81.57 361.77

Kenya 120.31 12.70 25.98Nigeria 68.17 3.50 102.63Tanzania 62.14 2.32 44.65Zimbabwe 831.40 42.98 55.62

Economic development = quality of life

Correlation with GDP per capita based on PPP

Life expectancy at birth 0.61554089Child mortality rate -0.597142331Healthcare expenditures per capita 0.898003539% of population with improved water access 0.542805766Internet users per 1000 people 0.87013155

Measuring economic development

• Country’s income – Production generates income– GDP versus GNP

• Average standard of living– GNP (GDP) per capita– Purchasing Price Parity (PPP)

Comparing Incomes Across Countries

PPP GDP per capita as a measure of the standardof living.

Standard of living: Income/Prices• Read GDP as a measure of income• Adjustment for the cost of living: difference in prices

Purchasing Price Parity – adjustment for the costof living. Prices differ across countries creating differences in purchasing power of money. For instance, 1000 USD buys more (today, probably less) in Moscow than in Atlanta.

Constructing a cost of living index• Fixing a market basket• Tracking that market basket through different

locations

Economic growth = GDP per capita (or per worker) growth

• Historical Context*– 1580 – 1820: The Netherlands 0.2%– 1820 – 1890: UK 1.2%– 1890 – 1989: USA 2.2%– 1990 – 2000: USA 1.93% (GDP per capita)– 1994 – 2000: USA 2.7% (GDP per capita)

* Growth in GDP per worker hour

Group GDP (constant 1995 US$) (bill) GDP per capita (PPP) Population (millions)

World 34,490 7,442 6,130High income 27,960 26,650 957Middle income 5,324 5,520 2,667Low income 1,202 2,230 2,506Sub-Saharan Africa 382 1,826 674Middle East & North Africa 599 5,501 301South Asia 649 2,580 1,378Latin America & Caribbean 2,001 7,198 524European Monetary Union 8,151 23,942 307East Asia & Pacific 1,803 3,854 1,823

2001 output indicators and population

High-income economies are those in which 2001 GNI per capita was $9,206 or moreMiddle-income economies are those in which 2001 GNI per capita was between $745 and $9,205

The World Economy

Less than 17101710-35603560-6250

6250-15110Over 15110No data available

GNI per capita in 2001, PPP method (current international $)World Bank Development Indicators for 2003

Real GDP growth rate in 2000 World Bank Development Indicators 2003

Less than –0.6-0.6 < . < 0.80.8 < / <2.1

2.1 < . < 4.2Over 4.2No data available

Economic Theory of Growth

• Resource endowment– Land– Natural Resources (typically part of Land)– Physical Capital– Human Capital– Entrepreneurship

• Institutional Support– Political system and its stability– Legal system– Property rights– Tax system

• Country specific factors– Business culture

LAND• Malthusian View of Economic Growth

– Land is fixed– Population growth is positive– Ratio of Land to Workers continuously declines

• Q = f ( Labor, Land)– Land is fixed– Diminishing marginal return to labor

• As labor increases, additional unit of labor contributes less to the output than the previous unit of labor

LandLaborQ If <1 labor exhibits diminishing marginal propertyThe ratio of output to labor (GDP per worker) decreases as

labor increases

Technological progress is ignored, but the technological progress canenhance the productivity of labor. Recall that technology in this contextrefers to production methods.

Natural Resources

• Typically defined together with Land

• In many ways similar properties to those of Land

Physical Capital

• Can make labor more productive

Assume Labor = 101; Land = 101

And the production function is: CapitalLandLaborQ

• If Capital is zero Q = 16• if Capital is 2 Q = 19.7• If Capital is 10 Q = 32• If Capital is 101 Q = 64

This example implies that economic growth can be achieved by simply accumulating physical capital

From Savings to Investment: The Harrod–Domar Model of Economic Growth

• What is being saved today can be used productively tomorrow

• Output produced can either be consumer or saved:

Y = C + S• Savings translate into investment S = I

Y = C + I

Capital Evolution Equationmodeling changes in the capital stock overtime

• Addition to capital stock at time period t– Investment: It

• Subtraction from capital stock at time period t– Depreciation: Kt

– Where represents the rate of depreciation of the capital stock and K the level of capital stock

• Kt+1= Kt – Kt + It

• Savings Rate: s = S/Y = I/Y• Capital to output ratio: K/Y = • Yt+1 = Yt – Yt + s Yt

Harrod-Domar Equation

s

Y

YY

t

tt 1

Importance of savings to economic growth

Importance of capital productivity to economic growth

Importance of Capital Formation

• The Marshal Plan for reconstruction of Europe and Japan

• The Soviet experience• The US in the 1990’s

– Not domestic but foreign savings!– Investment growth lead the economic boom of

the 1990’s (BEA website for stats)

Incorporating population growth

• Population evolution:Pt+1 = Pt (1 + n ), where n represents population growth

• Lower case letters refer to per capita values: kt = Kt/Pt; yt = Yt/Pt

• Per capita GDP growth (g’):

11

1'

n

sg

• A more intuitive expression is: g’ ~ s/ – – n • Long-term growth is driven by capital productivity () and the savings rate (s).

Assume:

Capital stock = 10,000

Output = 2,000 = 5 %

What should the savings rate be to ensure the long-term growth of 5%?

What should the savings rate be if the productivity of capital improves, and the 10000 capital stock results in the production of 4000 units of output?

What if population growth of 5% were introduced in part 1?

Weaknesses of the model

• Savings rate is exogenous – Subsistence consumption makes savings a function of income

• Capital to output ratio is exogenous– In the H-D model it is assumed to be driven mainly by

technological progress– However, can be impacted by relative endowments of

resources. If labor is scarce then wage rate increases relative to the cost of capital, and as a result increases

• Population growth is exogenous– Population growth is likely to depend on the level of economic

development• Opportunity cost of time• Retirement provisions

The Solow Model• Allows to make endogenous by introducing the

production function with input substitutability and diminishing marginal productivity

• Capital Evolution Equation:Kt+1 = Kt – Kt + s Yt

Note, no more • Adjusting by population growth:

kt+1 (1+n) = (1 – ) kt + s yt

Note: yt = f ( kt )(1-)k+sy

(1+n)k

Steady State

• Capital per capita remains constant over time• Achieved when:

k / f(k) = s / (n + )– Savings increase k/y ratio thereby increasing y– Depreciation reduces k/y ration thereby decreasing y– Population growth:

• Lowers the ratio of k/y, thereby reducing y• Increases total income growth ( Y ) and creates long-term

growth in Y equal to population growth (steady state

• Solow model and the post war Europe

Assume:

Y = L^(1/3) K^(2/3)

s = 10%

n = 0

What is the steady state level of capital per capita? What is the level of output per capita? What if n is set to 5%?

Convergence I• Growth Neutrality (H-D)

– Constant returns to capital• Unconditional convergence (S-G): convergence to the same k*

– Baumol’s 1986 study• 16 wealthy countries• Ln(1979)-ln(1870) = ln(1870) • The study showed complete convergence: almost all of the initial gap in

GDP per capita is closed• Problems:

– Too few countries– All countries selected are wealthy in 1979, hence have converged or stayed

wealthy

– De Long’s 1988 adjustment• Seven more countries included • The included nations appear similar to the original 16 countries based on

1870’s characteristics• is indistinguishable from zero

– Barro 1991 • large set of countries over a short time period• no correlation between average per capita growth and the starting GDP

level.

Convergence II

• Conditional Convergence (S-G)– Country specific parameters

• Savings rate; population growth; state of technology• Different steady-states: no unconditional convergence

– Technology is the only source of long-term growth• Assuming that technological spread is the same across the

world: differences in parameters of the model lead to convergence in growth rates

– Mankiw, Romer and Weil (1992)• Ln y = A + ln s + ln n + ln (• S and n explain almost 60% of the variation in GDPs across

countries

Human capitalendogeneity of growth

• Yt = Ktt

• Two forms of investment– Into physical capital: K = sY

• kt+1 = kt (1-)+syt k = s (h/k)^(1-) – – Into human capital: H = qY

• ht+1= ht + qyt h = q (h/k)^(-)– y = k + (1-) h

• Endogenous growth• Convergence in growth rates and not in per capita values• Formation of human capital

– Education– Industry composition– Direct foreign investment

• Lack of low-skilled labor in the production function• Input prices

– Brain drain

Technological Progress:long-term growth in the Solow Model

• Productivity of labor

• “effective” labor: L = E P– P – population– E – productivity coefficient

– Productivity growth: Et+1 = (1 + ) Et

– Yt = Lt1- Kt

yt = Et1-kt

– Productivity growth long term growth in output per capita

Technological Progress: endogenous explanation

• Romer, 1990

• Human capital– Productive resource: uH– Investment into research: (1-u)H

• Investment into research at the expense of current output

• Across time growth variation

Technological Progress: externality approach

• Output of each firm is impacted by investment done by other firms– “network” externality

• Yt=Et KtLt

1-

– Although K exhibits diminishing returns, it is possible to have an increasing return given E’s dependency on K-average

– External effects and central planning– Complementarities

• Multiple equilibrium paths: depending on the expectations of the firms

Technological Progress: Growth in Total Factor Productivity

Y/Yt = (MPK Kt)/Yt + (MPL Lt)/Yt + TFPG

Income Distribution, Poverty and Growth

• Distribution of Income– Current– Life-time

• Older versus younger generations

– Functional (source) characteristics of the distribution

• Income and the Utility Function• Distribution of Consumption Spending• Distribution of Wealth

Measuring income inequality

• Basis for inequality measures– Anonymity– Scale– Relative income– Changes in the distribution, i.e. the Dalton

principle• I(x1, x2, x3, x4)<I(x1, x2-e, x3+e, x4)• Regressive versus progressive

Visualizing Inequality: The Lorenz Curve

100%

100% Population share

Income share

25% 50% 75%

GINI Coefficient

• Differences approach: |Ii – Ik|

m

j

m

ijiij IInn

nG ||

2

12

• Gini Coefficient and the Lorenz Curve

Income Distribution and Development

• State of development of the banking sector and the availability of loanable funds

• Income distribution and the state of economic development– The Inverted U-hypothesis

• Poverty– Unemployment due to “subsistence” wages– Urban Poverty

Correcting for Income Inequalitythrough Taxation

• Progressive Taxation– Income Taxation

• USA case• Russian Case

• Wage Regulations