Advanced Macroeconomics 4th Edition PDF

This page intentionally left blank  ADVANCED MACROECONOMICS Fourth Edition i The McGraw-Hill Series in Economics ESSENTIALS OF Slavin MONEY AND BANKING ECONOMICS Economics, Cecchetti and Schoenholt...

This page intentionally left blank  ADVANCED MACROECONOMICS Fourth Edition i The McGraw-Hill Series in Economics ESSENTIALS OF Slavin MONEY AND BANKING ECONOMICS Economics, Cecchetti and Schoenholtz Brue, McConnell, and Flynn Microeconomics, and Money, Banking, and Essentials of Economics Macroeconomics Financial Markets Second Edition Tenth Edition Third Edition Mandel ECONOMICS OF SOCIAL Economics: The Basics URBAN ECONOMICS ISSUES First Edition O’Sullivan Guell Urban Economics Schiller Issues in Economics Today Seventh Edition Essentials of Economics Fifth Edition Eighth Edition LABOR ECONOMICS Sharp, Register, and Grimes Economics of Social Issues Borjas PRINCIPLES OF ECONOMICS Nineteenth Edition Labor Economics Colander Fifth Edition Economics, ECONOMETRICS Microeconomics, and McConnell, Brue, and Gujarati and Porter Macpherson Macroeconomics Basic Econometrics Contemporary Labor Eighth Edition Fifth Edition Economics Frank and Bernanke Gujarati and Porter Ninth Edition Principles of Economics, Essentials of Econometrics Principles of Fourth Edition PUBLIC FINANCE Microeconomics, Principles Rosen and Gayer of Macroeconomics MANAGERIAL ECONOMICS Public Finance Fourth Edition Baye Ninth Edition Frank and Bernanke Managerial Economics and Seidman Brief Editions: Principles of Business Strategy Public Finance Economics, Principles of Eighth Edition First Edition Microeconomics, Principles Brickley, Smith, and of Macroeconomics Zimmerman ENVIRONMENTAL Second Edition Managerial Economics and ECONOMICS McConnell, Brue, and Flynn Organizational Architecture Field and Field Economics, Fifth Edition Environmental Economics: Microeconomics, An Introduction Thomas and Maurice Macroeconomics Fifth Edition Managerial Economics Nineteenth Edition Tenth Edition McConnell, Brue, and Flynn INTERNATIONAL Brief Editions: INTERMEDIATE ECONOMICS Microeconomics and ECONOMICS Appleyard, Field, and Cobb Macroeconomics Bernheim and Whinston International Economics First Edition Microeconomics Seventh Edition Miller First Edition King and King Principles of Dornbusch, Fischer, and International Economics, Microeconomics Startz Globalization, and Policy: First Edition Macroeconomics A Reader Eleventh Edition Fifth Edition Samuelson and Nordhaus Economics, Frank Pugel Microeconomics, and Microeconomics and International Economics Macroeconomics Behavior Fourteenth Edition Nineteenth Edition Eighth Edition Schiller The Economy Today, The ADVANCED ECONOMICS Micro Economy Today, and Romer The Macro Economy Today Advanced Macroeconomics Twelfth Edition Fourth Edition ii  ADVANCED MACROECONOMICS Fourth Edition David Romer University of California, Berkeley iii Romer-1820130 rom11374˙fm˙i-xx February 17, 2011 8:12 iv ADVANCED MACROECONOMICS, FOURTH EDITION Published by McGraw-Hill, a business unit of The McGraw-Hill Companies, Inc., 1221 Avenue of the Americas, New York, NY, 10020. Copyright  c 2012 by The McGraw-Hill Companies, Inc. All rights reserved. Previous editions c 2006, 2001, and 1996. No part of this publication may be reproduced or distributed in any form or by any means, or stored in a database or retrieval system, without the prior written consent of The McGraw-Hill Companies, Inc., including, but not limited to, in any network or other electronic storage or transmission, or broadcast for distance learning. Some ancillaries, including electronic and print components, may not be available to customers outside the United States. This book is printed on acid-free paper. 1 2 3 4 5 6 7 8 9 0 DOC/DOC 1 0 9 8 7 6 5 4 3 2 1 ISBN 978-0-07-351137-5 MHID 0-07-351137-4 Vice President & Editor-in-Chief: Brent Gordon Vice President EDP/Central Publishing Services: Kimberly Meriwether David Publisher: Douglas Reiner Marketing Manager: Dean Karampelas Managing Developmental Editor: Christina Kouvelis Editorial Coordinator: Alyssa Otterness Project Manager: Robin A. Reed Design Coordinator: Margarite Reynolds Cover Designer: Studio Montage, St. Louis, Missouri Buyer: Nicole Baumgartner Media Project Manager: Balaji Sundararaman Compositor: MPS Limited, a Macmillan Company Typeface: 9.25/12 Lucida Bright Printer: R. R. Donnelley Library of Congress Cataloging-in-Publication Data Romer, David. Advanced macroeconomics / David Romer. — 4th ed. p. cm. ISBN 978-0-07-351137-5 1. Macroeconomics. I. Title. HB172.5.R66 2012 339—dc22 2010040893 www.mhhe.com iv To Christy v This page intentionally left blank  ABOUT THE AUTHOR David Romer is the Royer Professor in Political Economy at the Univer- sity of California, Berkeley, where he has been on the faculty since 1988. He is also co-director of the program in Monetary Economics at the National Bureau of Economic Research. He received his A.B. from Princeton Univer- sity and his Ph.D. from the Massachusetts Institute of Technology. He has been on the faculty at Princeton and has been a visiting faculty member at M.I.T. and Stanford University. At Berkeley, he is a three-time recipient of the Graduate Economic Association’s distinguished teaching and advis- ing awards. He is a fellow of the American Academy of Arts and Sciences, a former member of the Executive Committee of the American Economic Association, and co-editor of the Brookings Papers on Economic Activity. Most of his recent research focuses on monetary and fiscal policy; this work considers both the effects of policy on the economy and the determinants of policy. His other research interests include the foundations of price stick- iness, empirical evidence on economic growth, and asset-price volatility. He is married to Christina Romer, with whom he frequently collaborates. They have three children, Katherine, Paul, and Matthew. vii This page intentionally left blank  CONTENTS IN BRIEF Introduction 1 Chapter 1 THE SOLOW GROWTH MODEL 6 Chapter 2 INFINITE-HORIZON AND OVERLAPPING-GENERATIONS MODELS 49 Chapter 3 ENDOGENOUS GROWTH 101 Chapter 4 CROSS-COUNTRY INCOME DIFFERENCES 150 Chapter 5 REAL-BUSINESS-CYCLE THEORY 189 Chapter 6 NOMINAL RIGIDITY 238 Chapter 7 DYNAMIC STOCHASTIC GENERAL- EQUILIBRIUM MODELS OF FLUCTUATIONS 312 Chapter 8 CONSUMPTION 365 Chapter 9 INVESTMENT 405 Chapter 10 UNEMPLOYMENT 456 Chapter 11 INFLATION AND MONETARY POLICY 513 Chapter 12 BUDGET DEFICITS AND FISCAL POLICY 584 Epilogue THE FINANCIAL AND MACROECONOMIC CRISIS OF 2008 AND BEYOND 644 References 649 Indexes 686 ix This page intentionally left blank  CONTENTS Preface to the Fourth Edition xix Introduction 1 Chapter 1 THE SOLOW GROWTH MODEL 6 1.1 Some Basic Facts about Economic Growth 6 1.2 Assumptions 10 1.3 The Dynamics of the Model 15 1.4 The Impact of a Change in the Saving Rate 18 1.5 Quantitative Implications 23 1.6 The Solow Model and the Central Questions of Growth Theory 27 1.7 Empirical Applications 30 1.8 The Environment and Economic Growth 37 Problems 45 Chapter 2 INFINITE-HORIZON AND OVERLAPPING-GENERATIONS MODELS 49 Part A THE RAMSEY–CASS–KOOPMANS MODEL 49 2.1 Assumptions 49 2.2 The Behavior of Households and Firms 51 2.3 The Dynamics of the Economy 57 2.4 Welfare 63 2.5 The Balanced Growth Path 64 2.6 The Effects of a Fall in the Discount Rate 66 2.7 The Effects of Government Purchases 71 Part B THE DIAMOND MODEL 77 2.8 Assumptions 77 2.9 Household Behavior 78 2.10 The Dynamics of the Economy 81 xi xii CONTENTS 2.11 The Possibility of Dynamic Inefficiency 88 2.12 Government in the Diamond Model 92 Problems 93 Chapter 3 ENDOGENOUS GROWTH 101 3.1 Framework and Assumptions 102 3.2 The Model without Capital 104 3.3 The General Case 111 3.4 The Nature of Knowledge and the Determinants of the Allocation of Resources to R&D 116 3.5 The Romer Model 123 3.6 Empirical Application: Time-Series Tests of Endogenous Growth Models 134 3.7 Empirical Application: Population Growth and Technological Change since 1 Million B.C. 138 3.8 Models of Knowledge Accumulation and the Central Questions of Growth Theory 143 Problems 145 Chapter 4 CROSS-COUNTRY INCOME DIFFERENCES 150 4.1 Extending the Solow Model to Include Human Capital 151 4.2 Empirical Application: Accounting for Cross-Country Income Differences 156 4.3 Social Infrastructure 162 4.4 Empirical Application: Social Infrastructure and Cross-Country Income Differences 164 4.5 Beyond Social Infrastructure 169 4.6 Differences in Growth Rates 178 Problems 183 Chapter 5 REAL-BUSINESS-CYCLE THEORY 189 5.1 Introduction: Some Facts about Economic Fluctuations 189 5.2 An Overview of Business-Cycle Research 193 5.3 A Baseline Real-Business-Cycle Model 195 5.4 Household Behavior 197 5.5 A Special Case of the Model 201 5.6 Solving the Model in the General Case 207  CONTENTS xiii 5.7 Implications 211 5.8 Empirical Application: Calibrating a Real-Business- Cycle Model 217 5.9 Empirical Application: Money and Output 220 5.10 Assessing the Baseline Real-Business-Cycle Model 226 Problems 233 Chapter 6 NOMINAL RIGIDITY 238 Part A EXOGENOUS NOMINAL RIGIDITY 239 6.1 A Baseline Case: Fixed Prices 239 6.2 Price Rigidity, Wage Rigidity, and Departures from Perfect Competition in the Goods and Labor Markets 244 6.3 Empirical Application: The Cyclical Behavior of the Real Wage 253 6.4 Toward a Usable Model with Exogenous Nominal Rigidity 255 Part B MICROECONOMIC FOUNDATIONS OF INCOMPLETE NOMINAL ADJUSTMENT 267 6.5 A Model of Imperfect Competition and Price-Setting 268 6.6 Are Small Frictions Enough? 275 6.7 Real Rigidity 278 6.8 Coordination-Failure Models and Real Non- Walrasian Theories 286 6.9 The Lucas Imperfect-Information Model 292 6.10 Empirical Application: International Evidence on the Output-Inflation Tradeoff 302 Problems 306 Chapter 7 DYNAMIC STOCHASTIC GENERAL- EQUILIBRIUM MODELS OF FLUCTUATIONS 312 7.1 Building Blocks of Dynamic New Keynesian Models 315 7.2 Predetermined Prices: The Fischer Model 319 7.3 Fixed Prices: The Taylor Model 322 7.4 The Calvo Model and the New Keynesian Phillips Curve 329 xiv CONTENTS 7.5 State-Dependent Pricing 332 7.6 Empirical Applications 337 7.7 Models of Staggered Price Adjustment with Inflation Inertia 344 7.8 The Canonical New Keynesian Model 352 7.9 Other Elements of Modern New Keynesian DSGE Models of Fluctuations 356 Problems 361 Chapter 8 CONSUMPTION 365 8.1 Consumption under Certainty: The Permanent- Income Hypothesis 365 8.2 Consumption under Uncertainty: The Random- Walk Hypothesis 372 8.3 Empirical Application: Two Tests of the Random- Walk Hypothesis 375 8.4 The Interest Rate and Saving 380 8.5 Consumption and Risky Assets 384 8.6 Beyond the Permanent-Income Hypothesis 389 Problems 398 Chapter 9 INVESTMENT 405 9.1 Investment and the Cost of Capital 405 9.2 A Model of Investment with Adjustment Costs 408 9.3 Tobin’s q 414 9.4 Analyzing the Model 415 9.5 Implications 419 9.6 Empirical Application: q and Investment 425 9.7 The Effects of Uncertainty 428 9.8 Kinked and Fixed Adjustment Costs 432 9.9 Financial-Market Imperfections 436 9.10 Empirical Application: Cash Flow and Investment 447 Problems 451 Chapter 10 UNEMPLOYMENT 456 10.1 Introduction: Theories of Unemployment 456 10.2 A Generic Efficiency-Wage Model 458 10.3 A More General Version 463  CONTENTS xv 10.4 The Shapiro–Stiglitz Model 467 10.5 Contracting Models 478 10.6 Search and Matching Models 486 10.7 Implications 493 10.8 Empirical Applications 498 Problems 506 Chapter 11 INFLATION AND MONETARY POLICY 513 11.1 Inflation, Money Growth, and Interest Rates 514 11.2 Monetary Policy and the Term Structure of Interest Rates 518 11.3 The Microeconomic Foundations of Stabilization Policy 523 11.4 Optimal Monetary Policy in a Simple Backward- Looking Model 531 11.5 Optimal Monetary Policy in a Simple Forward- Looking Model 537 11.6 Additional Issues in the Conduct of Monetary Policy 542 11.7 The Dynamic Inconsistency of Low-Inflation Monetary Policy 554 11.8 Empirical Applications 562 11.9 Seignorage and Inflation 567 Problems 576 Chapter 12 BUDGET DEFICITS AND FISCAL POLICY 584 12.1 The Government Budget Constraint 586 12.2 The Ricardian Equivalence Result 592 12.3 Ricardian Equivalence in Practice 594 12.4 Tax-Smoothing 598 12.5 Political-Economy Theories of Budget Deficits 604 12.6 Strategic Debt Accumulation 607 12.7 Delayed Stabilization 617 12.8 Empirical Application: Politics and Deficits in Industrialized Countries 623 12.9 The Costs of Deficits 628 12.10 A Model of Debt Crises 632 Problems 639 xvi CONTENTS Epilogue THE FINANCIAL AND MACROECONOMIC CRISIS OF 2008 AND BEYOND 644 References 649 Author Index 686 Subject Index 694  EMPIRICAL APPLICATIONS Section 1.7 Growth Accounting 30 Convergence 32 Saving and Investment 36 Section 2.7 Wars and Real Interest Rates 75 Section 2.11 Are Modern Economies Dynamically Efficient? 90 Section 3.6 Time-Series Tests of Endogenous Growth Models 134 Section 3.7 Population Growth and Technological Change since 1 Million B.C. 138 Section 4.2 Accounting for Cross-Country Income Differences 156 Section 4.4 Social Infrastructure and Cross-Country Income Differences 164 Section 4.5 Geography, Colonialism, and Economic Development 174 Section 5.8 Calibrating a Real-Business-Cycle Model 217 Section 5.9 Money and Output 220 Section 6.3 The Cyclical Behavior of the Real Wage 253 Section 6.8 Experimental Evidence on Coordination-Failure Games 289 Section 6.10 International Evidence on the Output-Inflation Tradeoff 302 Section 7.6 Microeconomic Evidence on Price Adjustment 337 Inflation Inertia 340 Section 8.1 Understanding Estimated Consumption Functions 368 Section 8.3 Campbell and Mankiw’s Test Using Aggregate Data 375 Shea’s Test Using Household Data 377 Section 8.5 The Equity-Premium Puzzle 387 Section 8.6 Credit Limits and Borrowing 395 Section 9.6 q and Investment 425 Section 9.10 Cash Flow and Investment 447 Section 10.8 Contracting Effects on Employment 498 Interindustry Wage Differences 501 Survey Evidence on Wage Rigidity 504 Section 11.2 The Term Structure and Changes in the Federal Reserve’s Funds-Rate Target 520 Section 11.6 Estimating Interest-Rate Rules 548 Section 11.8 Central-Bank Independence and Inflation 562 The Great Inflation 564 Section 12.1 Is U.S. Fiscal Policy on a Sustainable Path? 590 Section 12.8 Politics and Deficits in Industrialized Countries 623 xvii This page intentionally left blank  PREFACE TO THE FOURTH EDITION Keeping a book on macroeconomics up to date is a challenging and never- ending task. The field is continually evolving, as new events and research lead to doubts about old views and the emergence of new ideas, models, and tests. The result is that each edition of this book is very different from the one before. This is truer of this revision than any previous one. The largest changes are to the material on economic growth and on short- run fluctuations with incomplete price flexibility. I have split the old chapter on new growth theory in two. The first chapter (Chapter 3) covers models of endogenous growth, and has been updated to include Paul Romer’s now- classic model of endogenous technological progress. The second chapter (Chapter 4) focuses on the enormous income differences across countries. This material includes a much more extensive consideration of the chal- lenges confronting empirical work on cross-country income differences and of recent work on the underlying determinants of those differences. Chapters 6 and 7 on short-run fluctuations when prices are not fully flex- ible have been completely recast. This material is now grounded in micro- economic foundations from the outset. It proceeds from simple models with exogenously fixed prices to the microeconomic foundations of price sticki- ness in static and dynamic settings, to the canonical three-equation new Key- nesian model (the new Keynesian IS curve, the new Keynesian Phillips curve, and an interest-rate rule), to the ingredients of modern dynamic stochastic general-equilibrium models of fluctuations. These revisions carry over to the analysis of monetary policy in Chapter 11. This chapter has been entirely reorganized and is now much more closely tied to the earlier analyses of short-run fluctuations, and it includes a careful treatment of optimal policy in forward-looking models. The two other chapters where I have made major changes are Chapter 5 on real-business-cycle models of fluctuations and Chapter 10 on the labor market and unemployment. In Chapter 5, the empirical applications and the analysis of the relation between real-business-cycle theory and other mod- els of fluctuations have been overhauled. In Chapter 10, the presentation of search-and-matching models of the labor market has been revamped and greatly expanded, and the material on contracting models has been sub- stantially compressed. xix xx PREFACE Keeping the book up to date has been made even more challenging by the financial and macroeconomic crisis that began in 2008. I have delib- erately chosen not to change the book fundamentally in response to the crisis: although I believe that the crisis will lead to major changes in macro- economics, I also believe that it is too soon to know what those changes will be. I have therefore taken the approach of bringing in the crisis where it is relevant and of including an epilogue that describes some of the main issues that the crisis raises for macroeconomics. But I believe that it will be years before we have a clear picture of how the crisis is changing the field. For additional reference and general information, please refer to the book’s website at www.mhhe.com/romer4e. Also available on the website, under the password-protected Instructor Edition, is the Solutions Manual. Print versions of the manual are available by request only—if interested, please contact your McGraw-Hill/Irwin representative. This book owes a great deal to many people. The book is an outgrowth of courses I have taught at Princeton University, the Massachusetts Institute of Technology, Stanford University, and especially the University of California, Berkeley. I want to thank the many students in these courses for their feed- back, their patience, and their encouragement. Four people have provided detailed, thoughtful, and constructive com- ments on almost every aspect of the book over multiple editions: Laurence Ball, A. Andrew John, N. Gregory Mankiw, and Christina Romer. Each has significantly improved the book, and I am deeply grateful to them for their efforts. In addition to those four, Susanto Basu, Robert Hall, and Ricardo Reis provided extremely valuable guidance that helped shape the revisions in this edition. Many other people have made valuable comments and suggestions con- cerning some or all of the book. I would particularly like to thank James Butkiewicz, Robert Chirinko, Matthew Cushing, Charles Engel, Mark Gertler, Robert Gordon, Mary Gregory, Tahereh Alavi Hojjat, A. Stephen Holland, Hiroo Iwanari, Frederick Joutz, Pok-sang Lam, Gregory Linden, Maurice Obtsfeld, Jeffrey Parker, Stephen Perez, Kerk Phillips, Carlos Ramirez, Robert Rasche, Joseph Santos, Peter Skott, Peter Temin, Henry Thompson, Matias Vernengo, and Steven Yamarik. Jeffrey Rohaly prepared the superb Solutions Manual. Salifou Issoufou updated the tables and figures. Tyler Arant, Zachary Breig, Chen Li, and Melina Mattos helped draft solutions to the new problems and assisted with proofreading. Finally, the editorial and production staff at McGraw-Hill did an excellent job of turning the manuscript into a finished product. I thank all these people for their help.  INTRODUCTION Macroeconomics is the study of the economy as a whole. It is therefore con- cerned with some of the most important questions in economics. Why are some countries rich and others poor? Why do countries grow? What are the sources of recessions and booms? Why is there unemployment, and what determines its extent? What are the sources of inflation? How do govern- ment policies affect output, unemployment, inflation, and growth? These and related questions are the subject of macroeconomics. This book is an introduction to the study of macroeconomics at an ad- vanced level. It presents the major theories concerning the central questions of macroeconomics. Its goal is to provide both an overview of the field for students who will not continue in macroeconomics and a starting point for students who will go on to more advanced courses and research in macroeconomics and monetary economics. The book takes a broad view of the subject matter of macroeconomics. A substantial portion of the book is devoted to economic growth, and separate chapters are devoted to the natural rate of unemployment, inflation, and budget deficits. Within each part, the major issues and competing theories are presented and discussed. Throughout, the presentation is motivated by substantive questions about the world. Models and techniques are used extensively, but they are treated as tools for gaining insight into important issues, not as ends in themselves. The first four chapters are concerned with growth. The analysis focuses on two fundamental questions: Why are some economies so much richer than others, and what accounts for the huge increases in real incomes over time? Chapter 1 is devoted to the Solow growth model, which is the basic reference point for almost all analyses of growth. The Solow model takes technological progress as given and investigates the effects of the division of output between consumption and investment on capital accumulation and growth. The chapter presents and analyzes the model and assesses its ability to answer the central questions concerning growth. Chapter 2 relaxes the Solow model’s assumption that the saving rate is exogenous and fixed. It covers both a model where the set of households in 1 2 INTRODUCTION the economy is fixed (the Ramsey model) and one where there is turnover (the Diamond model). Chapter 3 presents the new growth theory. It begins with models where technological progress arises from resources being devoted to the develop- ment of new ideas, but where the division of resources between the produc- tion of ideas and the production of conventional goods is taken as given. It then considers the determinants of that division. Chapter 4 focuses specifically on the sources of the enormous differ- ences in average incomes across countries. This material, which is heavily empirical, emphasizes two issues. The first is the contribution of variations in the accumulation of physical and human capital and in output for given quantities of capital to cross-country income differences. The other is the determinants of those variations. Chapters 5 through 7 are devoted to short-run fluctuations—the year-to- year and quarter-to-quarter ups and downs of employment, unemployment, and output. Chapter 5 investigates models of fluctuations where there are no imperfections, externalities, or missing markets and where the economy is subject only to real disturbances. This presentation of real-business-cycle theory considers both a baseline model whose mechanics are fairly transpar- ent and a more sophisticated model that incorporates additional important features of fluctuations. Chapters 6 and 7 then turn to Keynesian models of fluctuations. These models are based on sluggish adjustment of nominal prices and wages, and emphasize monetary as well as real disturbances. Chapter 6 focuses on basic features of price stickiness. It investigates baseline models where price stickiness is exogenous and the microeconomic foundations of price stickiness in static settings. Chapter 7 turns to dynamics. It first exam- ines the implications of alternative assumptions about price adjustment in dynamic settings. It then turns to dynamic stochastic general-equilibrium models of fluctuations with price stickiness—that is, fully specified general- equilibrium models of fluctuations that incorporate incomplete nominal price adjustment. The analysis in the first seven chapters suggests that the behavior of consumption and investment is central to both growth and fluctuations. Chapters 8 and 9 therefore examine the determinants of consumption and investment in more detail. In each case, the analysis begins with a baseline model and then considers alternative views. For consumption, the baseline is the permanent-income hypothesis; for investment, it is q theory. Chapter 10 turns to the labor market. It focuses on the determinants of an economy’s natural rate of unemployment. The chapter also investigates the impact of fluctuations in labor demand on real wages and employment. The main theories considered are efficiency-wage theories, contracting theories, and search and matching models. The final two chapters are devoted to macroeconomic policy. Chapter 11 investigates monetary policy and inflation. It starts by explaining the central  INTRODUCTION 3 role of money growth in causing inflation and by investigating the effects of money growth. It then considers optimal monetary policy. This analysis begins with the microeconomic foundations of the appropriate objective for policy, proceeds to the analysis of optimal policy in backward-looking and forward-looking models, and concludes with a discussion of a range of issues in the conduct of policy. The final sections of the chapter examine how excessive inflation can arise either from a short-run output-inflation tradeoff or from governments’ need for revenue from money creation. Chapter 12 is concerned with fiscal policy and budget deficits. The first part of the chapter describes the government’s budget constraint and investigates two baseline views of deficits: Ricardian equivalence and tax-smoothing. Most of the remainder of the chapter investigates theories of the sources of deficits. In doing so, it provides an introduction to the use of economic tools to study politics. Finally, a brief epilogue discusses the macroeconomic and financial crisis that began in 2007 and worsened dramatically in the fall of 2008. The focus is on the major issues that the crisis is likely to raise for the field of macroeconomics.1 Macroeconomics is both a theoretical and an empirical subject. Because of this, the presentation of the theories is supplemented with examples of relevant empirical work. Even more so than with the theoretical sections, the purpose of the empirical material is not to provide a survey of the literature; nor is it to teach econometric techniques. Instead, the goal is to illustrate some of the ways that macroeconomic theories can be applied and tested. The presentation of this material is for the most part fairly intuitive and presumes no more knowledge of econometrics than a general familiarity with regressions. In a few places where it can be done naturally, the empir- ical material includes discussions of the ideas underlying more advanced econometric techniques. Each chapter concludes with a set of problems. The problems range from relatively straightforward variations on the ideas in the text to extensions that tackle important issues. The problems thus serve both as a way for readers to strengthen their understanding of the material and as a compact way of presenting significant extensions of the ideas in the text. The fact that the book is an advanced introduction to macroeconomics has two main consequences. The first is that the book uses a series of for- mal models to present and analyze the theories. Models identify particular 1 The chapters are largely independent. The growth and fluctuations sections are almost entirely self-contained (although Chapter 5 builds moderately on Part A of Chapter 2). There is also considerable independence among the chapters in each section. Chapters 2, 3, and 4 can be covered in any order, and models of price stickiness (Chapters 6 and 7) can be covered either before or after real-business-cycle theory (Chapter 5). Finally, the last five chapters are largely self-contained. The main exception is that Chapter 11 on monetary policy builds on the analysis of models of fluctuations in Chapter 7. In addition, Chapter 8 relies moderately on Chapter 2 and Chapter 10 relies moderately on Chapter 6. 4 INTRODUCTION features of reality and study their consequences in isolation. They thereby allow us to see clearly how different elements of the economy interact and what their implications are. As a result, they provide a rigorous way of investigating whether a proposed theory can answer a particular question and whether it generates additional predictions. The book contains literally dozens of models. The main reason for this multiplicity is that we are interested in many issues. Features of the econ- omy that are crucial to one issue may be unimportant to others. Money, for example, is almost surely central to inflation but not to long-run growth. In- corporating money into models of growth would only obscure the analysis. Thus instead of trying to build a single model to analyze all the issues we are interested in, the book develops a series of models. An additional reason for the multiplicity of models is that there is consid- erable disagreement about the answers to many of the questions we will be examining. When there is disagreement, the book presents the leading views and discusses their strengths and weaknesses. Because different theories emphasize different features of the economy, again it is more enlightening to investigate distinct models than to build one model incorporating all the features emphasized by the different views. The second consequence of the book’s advanced level is that it presumes some background in mathematics and economics. Mathematics provides compact ways of expressing ideas and powerful tools for analyzing them. The models are therefore mainly presented and analyzed mathematically. The key mathematical requirements are a thorough understanding of single- variable calculus and an introductory knowledge of multivariable calculus. Tools such as functions, logarithms, derivatives and partial derivatives, max- imization subject to constraint, and Taylor-series approximations are used relatively freely. Knowledge of the basic ideas of probability—random vari- ables, means, variances, covariances, and independence—is also assumed. No mathematical background beyond this level is needed. More advanced tools (such as simple differential equations, the calculus of variations, and dynamic programming) are used sparingly, and they are explained as they are used. Indeed, since mathematical techniques are essential to further study and research in macroeconomics, models are sometimes analyzed in greater detail than is otherwise needed in order to illustrate the use of a particular method. In terms of economics, the book assumes an understanding of microeco- nomics through the intermediate level. Familiarity with such ideas as profit maximization and utility maximization, supply and demand, equilibrium, efficiency, and the welfare properties of competitive equilibria is presumed. Little background in macroeconomics itself is absolutely necessary. Read- ers with no prior exposure to macroeconomics, however, are likely to find some of the concepts and terminology difficult, and to find that the pace is rapid. These readers may wish to review an intermediate macroeconomics  INTRODUCTION 5 text before beginning the book, or to study such a book in conjunction with this one. The book was designed for first-year graduate courses in macroeco- nomics. But it can be used (either on its own or in conjunction with an intermediate text) for students with strong backgrounds in mathematics and economics in professional schools and advanced undergraduate pro- grams. It can also provide a tour of the field for economists and others working in areas outside macroeconomics. Romer-1820130 book February 15, 2011 9:24 6 Chapter 1 THE SOLOW GROWTH MODEL 1.1 Some Basic Facts about Economic Growth Over the past few centuries, standards of living in industrialized countries have reached levels almost unimaginable to our ancestors. Although com- parisons are difficult, the best available evidence suggests that average real incomes today in the United States and Western Europe are between 10 and 30 times larger than a century ago, and between 50 and 300 times larger than two centuries ago.1 Moreover, worldwide growth is far from constant. Growth has been rising over most of modern history. Average growth rates in the industrialized countries were higher in the twentieth century than in the nineteenth, and higher in the nineteenth than in the eighteenth. Further, average incomes on the eve of the Industrial Revolution even in the wealthiest countries were not dramatically above subsistence levels; this tells us that average growth over the millennia before the Industrial Revolution must have been very, very low. One important exception to this general pattern of increasing growth is the productivity growth slowdown. Average annual growth in output per person in the United States and other industrialized countries from the early 1970s to the mid-1990s was about a percentage point below its earlier level. The data since then suggest a rebound in productivity growth, at least in the United States. How long the rebound will last and how widespread it will be are not yet clear. 1 Maddison (2006) reports and discusses basic data on average real incomes over modern history. Most of the uncertainty about the extent of long-term growth concerns the behav- ior not of nominal income, but of the price indexes needed to convert those figures into estimates of real income. Adjusting for quality changes and for the introduction of new goods is conceptually and practically difficult, and conventional price indexes do not make these adjustments well. See Nordhaus (1997) and Boskin, Dulberger, Gordon, Griliches, and Jorgenson (1998) for discussions of the issues involved and analyses of the biases in con- ventional price indexes. 6  1.1 Some Basic Facts about Economic Growth 7 There are also enormous differences in standards of living across parts of the world. Average real incomes in such countries as the United States, Germany, and Japan appear to exceed those in such countries as Bangladesh and Kenya by a factor of about 20.2 As with worldwide growth, cross-country income differences are not immutable. Growth in individual countries often differs considerably from average worldwide growth; that is, there are often large changes in countries’ relative incomes. The most striking examples of large changes in relative incomes are growth miracles and growth disasters. Growth miracles are episodes where growth in a country far exceeds the world average over an extended period, with the result that the country moves rapidly up the world income distri- bution. Some prominent growth miracles are Japan from the end of World War II to around 1990, the newly industrializing countries (NICs) of East Asia (South Korea, Taiwan, Singapore, and Hong Kong) starting around 1960, and China starting around 1980. Average incomes in the NICs, for example, have grown at an average annual rate of over 5 percent since 1960. As a result, their average incomes relative to that of the United States have more than tripled. Growth disasters are episodes where a country’s growth falls far short of the world average. Two very different examples of growth disasters are Argentina and many of the countries of sub-Saharan Africa. In 1900, Argentina’s average income was only slightly behind those of the world’s leaders, and it appeared poised to become a major industrialized country. But its growth performance since then has been dismal, and it is now near the middle of the world income distribution. Sub-Saharan African countries such as Chad, Ghana, and Mozambique have been extremely poor through- out their histories and have been unable to obtain any sustained growth in average incomes. As a result, their average incomes have remained close to subsistence levels while average world income has been rising steadily. Other countries exhibit more complicated growth patterns. Côte d’Ivoire was held up as the growth model for Africa through the 1970s. From 1960 to 1978, real income per person grew at an average annual rate of 3.2 percent. But in the three decades since then, its average income has not increased at all, and it is now lower relative to that of the United States than it was in 1960. To take another example, average growth in Mexico was very high in the 1950s, 1960s, and 1970s, negative in most of the 1980s, and moderate— with a brief but severe interruption in the mid-1990s—since then. Over the whole of the modern era, cross-country income differences have widened on average. The fact that average incomes in the richest countries at the beginning of the Industrial Revolution were not far above subsistence 2 Comparisons of real incomes across countries are far from straightforward, but are much easier than comparisons over extended periods of time. The basic source for cross- country data on real income is the Penn World Tables. Documentation of these data and the most recent figures are available at http://pwt.econ.upenn.edu/. 8 Chapter 1 THE SOLOW GROWTH MODEL means that the overall dispersion of average incomes across different parts of the world must have been much smaller than it is today (Pritchett, 1997). Over the past few decades, however, there has been no strong tendency either toward continued divergence or toward convergence. The implications of the vast differences in standards of living over time and across countries for human welfare are enormous. The differences are associated with large differences in nutrition, literacy, infant mortality, life expectancy, and other direct measures of well-being. And the welfare con- sequences of long-run growth swamp any possible effects of the short-run fluctuations that macroeconomics traditionally focuses on. During an av- erage recession in the United States, for example, real income per person falls by a few percent relative to its usual path. In contrast, the productivity growth slowdown reduced real income per person in the United States by about 25 percent relative to what it otherwise would have been. Other exam- ples are even more startling. If real income per person in the Philippines con- tinues to grow at its average rate for the period 1960–2001 of 1.5 percent, it will take 150 years for it to reach the current U.S. level. If it achieves 3 per- cent growth, the time will be reduced to 75 years. And if it achieves 5 percent growth, as the NICs have done, the process will take only 45 years. To quote Robert Lucas (1988), “Once one starts to think about [economic growth], it is hard to think about anything else.” The first four chapters of this book are therefore devoted to economic growth. We will investigate several models of growth. Although we will examine the models’ mechanics in considerable detail, our goal is to learn what insights they offer concerning worldwide growth and income differ- ences across countries. Indeed, the ultimate objective of research on eco- nomic growth is to determine whether there are possibilities for raising overall growth or bringing standards of living in poor countries closer to those in the world leaders. This chapter focuses on the model that economists have traditionally used to study these issues, the Solow growth model.3 The Solow model is the starting point for almost all analyses of growth. Even models that depart fundamentally from Solow’s are often best understood through comparison with the Solow model. Thus understanding the model is essential to under- standing theories of growth. The principal conclusion of the Solow model is that the accumulation of physical capital cannot account for either the vast growth over time in output per person or the vast geographic differences in output per per- son. Specifically, suppose that capital accumulation affects output through the conventional channel that capital makes a direct contribution to pro- duction, for which it is paid its marginal product. Then the Solow model 3 The Solow model (which is sometimes known as the Solow–Swan model) was developed by Robert Solow (Solow, 1956) and T. W. Swan (Swan, 1956).  1.1 Some Basic Facts about Economic Growth 9 implies that the differences in real incomes that we are trying to under- stand are far too large to be accounted for by differences in capital inputs. The model treats other potential sources of differences in real incomes as either exogenous and thus not explained by the model (in the case of tech- nological progress, for example) or absent altogether (in the case of positive externalities from capital, for example). Thus to address the central ques- tions of growth theory, we must move beyond the Solow model. Chapters 2 through 4 therefore extend and modify the Solow model. Chapter 2 investigates the determinants of saving and investment. The Solow model has no optimization in it; it takes the saving rate as exogenous and constant. Chapter 2 presents two models that make saving endogenous and potentially time-varying. In the first, saving and consumption decisions are made by a fixed set of infinitely lived households; in the second, the decisions are made by overlapping generations of households with finite horizons. Relaxing the Solow model’s assumption of a constant saving rate has three advantages. First, and most important for studying growth, it demon- strates that the Solow model’s conclusions about the central questions of growth theory do not hinge on its assumption of a fixed saving rate. Second, it allows us to consider welfare issues. A model that directly specifies rela- tions among aggregate variables provides no way of judging whether some outcomes are better or worse than others: without individuals in the model, we cannot say whether different outcomes make individuals better or worse off. The infinite-horizon and overlapping-generations models are built up from the behavior of individuals, and can therefore be used to discuss wel- fare issues. Third, infinite-horizon and overlapping-generations models are used to study many issues in economics other than economic growth; thus they are valuable tools. Chapters 3 and 4 investigate more fundamental departures from the Solow model. Their models, in contrast to Chapter 2’s, provide different answers than the Solow model to the central questions of growth theory. Chapter 3 departs from the Solow model’s treatment of technological pro- gress as exogenous; it assumes instead that it is the result of the alloca- tion of resources to the creation of new technologies. We will investigate the implications of such endogenous technological progress for economic growth and the determinants of the allocation of resources to innovative activities. The main conclusion of this analysis is that endogenous technological progress is almost surely central to worldwide growth but probably has lit- tle to do with cross-country income differences. Chapter 4 therefore focuses specifically on those differences. We will find that understanding them re- quires considering two new factors: variation in human as well as physical capital, and variation in productivity not stemming from variation in tech- nology. Chapter 4 explores both how those factors can help us understand 10 Chapter 1 THE SOLOW GROWTH MODEL the enormous differences in average incomes across countries and potential sources of variation in those factors. We now turn to the Solow model. 1.2 Assumptions Inputs and Output The Solow model focuses on four variables: output (Y ), capital (K ), labor (L), and “knowledge” or the “effectiveness of labor” (A). At any time, the economy has some amounts of capital, labor, and knowledge, and these are combined to produce output. The production function takes the form Y (t ) = F (K (t ), A(t )L(t )), (1.1) where t denotes time. Notice that time does not enter the production function directly, but only through K , L, and A. That is, output changes over time only if the inputs to production change. In particular, the amount of output obtained from given quantities of capital and labor rises over time—there is technological progress—only if the amount of knowledge increases. Notice also that A and L enter multiplicatively. AL is referred to as effec- tive labor, and technological progress that enters in this fashion is known as labor-augmenting or Harrod-neutral.4 This way of specifying how A enters, together with the other assumptions of the model, will imply that the ratio of capital to output, K/Y, eventually settles down. In practice, capital-output ratios do not show any clear upward or downward trend over extended peri- ods. In addition, building the model so that the ratio is eventually constant makes the analysis much simpler. Assuming that A multiplies L is therefore very convenient. The central assumptions of the Solow model concern the properties of the production function and the evolution of the three inputs into production (capital, labor, and knowledge) over time. We discuss each in turn. Assumptions Concerning the Production Function The model’s critical assumption concerning the production function is that it has constant returns to scale in its two arguments, capital and effective labor. That is, doubling the quantities of capital and effective labor (for ex- ample, by doubling K and L with A held fixed) doubles the amount produced. 4 If knowledge enters in the form Y = F (AK , L), technological progress is capital- augmenting. If it enters in the form Y = AF (K , L), technological progress is Hicks-neutral.  1.2 Assumptions 11 More generally, multiplying both arguments by any nonnegative constant c causes output to change by the same factor: F (cK , cAL) = cF (K , AL) for all c ≥ 0. (1.2) The assumption of constant returns can be thought of as a combination of two separate assumptions. The first is that the economy is big enough that the gains from specialization have been exhausted. In a very small economy, there are likely to be enough possibilities for further specialization that doubling the amounts of capital and labor more than doubles output. The Solow model assumes, however, that the economy is sufficiently large that, if capital and labor double, the new inputs are used in essentially the same way as the existing inputs, and so output doubles. The second assumption is that inputs other than capital, labor, and knowl- edge are relatively unimportant. In particular, the model neglects land and other natural resources. If natural resources are important, doubling capital and labor could less than double output. In practice, however, as Section 1.8 describes, the availability of natural resources does not appear to be a major constraint on growth. Assuming constant returns to capital and labor alone therefore appears to be a reasonable approximation. The assumption of constant returns allows us to work with the produc- tion function in intensive form. Setting c = 1/AL in equation (1.2) yields   K 1 F ,1 = F (K , AL). (1.3) AL AL Here K /AL is the amount of capital per unit of effective labor, and F (K , AL)/ AL is Y/AL, output per unit of effective labor. Define k = K /AL, y = Y/AL, and f (k) = F (k,1). Then we can rewrite (1.3) as y = f (k). (1.4) That is, we can write output per unit of effective labor as a function of capital per unit of effective labor. These new variables, k and y , are not of interest in their own right. Rather, they are tools for learning about the variables we are interested in. As we will see, the easiest way to analyze the model is to focus on the behavior of k rather than to directly consider the behavior of the two arguments of the production function, K and AL. For example, we will determine the behavior of output per worker, Y/L, by writing it as A(Y/AL), or A f (k), and determining the behavior of A and k. To see the intuition behind (1.4), think of dividing the economy into AL small economies, each with 1 unit of effective labor and K /AL units of capi- tal. Since the production function has constant returns, each of these small economies produces 1/AL as much as is produced in the large, undivided economy. Thus the amount of output per unit of effective labor depends only on the quantity of capital per unit of effective labor, and not on the over- all size of the economy. This is expressed mathematically in equation (1.4). 12 Chapter 1 THE SOLOW GROWTH MODEL f (k) k FIGURE 1.1 An example of a production function The intensive-form production function, f (k), is assumed to satisfy f (0) = 0, f  (k) > 0, f  (k) < 0.5 Since F (K , AL) equals ALf (K /AL), it follows that the marginal product of capital, ∂F (K , AL)/∂K , equals ALf  (K /AL)(1/AL), which is just f  (k). Thus the assumptions that f  (k) is positive and f  (k) is negative imply that the marginal product of capital is positive, but that it declines as capital (per unit of effective labor) rises. In addition, f ( ) is assumed to satisfy the Inada conditions (Inada, 1964): limk→0 f  (k) = ∞, limk→∞ f  (k) = 0. These conditions (which are stronger than needed for the model’s central results) state that the marginal product of capital is very large when the capital stock is sufficiently small and that it becomes very small as the capital stock becomes large; their role is to ensure that the path of the economy does not diverge. A production function satisfying f  ( ) > 0, f  ( ) < 0, and the Inada conditions is shown in Figure 1.1. A specific example of a production function is the Cobb–Douglas function, F (K , AL) = K α(AL)1−α, 0 < α < 1. (1.5) This production function is easy to analyze, and it appears to be a good first approximation to actual production functions. As a result, it is very useful. 5 The notation f  ( ) denotes the first derivative of f ( ), and f  ( ) the second derivative.  1.2 Assumptions 13 It is easy to check that the Cobb–Douglas function has constant returns. Multiplying both inputs by c gives us F (cK , cAL) = (cK )α(cAL)1−α = c αc 1−α K α(AL)1−α (1.6) = cF (K , AL). To find the intensive form of the production function, divide both inputs by AL; this yields   K f (k) ≡ F ,1 AL  α K (1.7) = AL = k α. α−1 Equation (1.7) implies that f  (k) = αk. It is straightforward to check that this expression is positive, that it approaches infinity as k approaches zero, and that it approaches zero as k approaches infinity. Finally, f  (k) = α−2 −(1 − α)αk , which is negative.6 The Evolution of the Inputs into Production The remaining assumptions of the model concern how the stocks of labor, knowledge, and capital change over time. The model is set in continuous time; that is, the variables of the model are defined at every point in time.7 The initial levels of capital, labor, and knowledge are taken as given, and are assumed to be strictly positive. Labor and knowledge grow at constant rates: L̇(t ) = nL(t ), (1.8) Ȧ(t ) = gA(t ), (1.9) where n and g are exogenous parameters and where a dot over a variable denotes a derivative with respect to time (that is, Ẋ (t ) is shorthand for dX(t )/dt). 6 Note that with Cobb–Douglas production, labor-augmenting, capital-augmenting, and Hicks-neutral technological progress (see n. 4) are all essentially the same. For example, to rewrite (1.5) so that technological progress is Hicks-neutral, simply define à = A 1−α; then Y = Ã(K α L 1−α). 7 The alternative is discrete time, where the variables are defined only at specific dates (usually t = 0,1,2,...). The choice between continuous and discrete time is usually based on convenience. For example, the Solow model has essentially the same implications in discrete as in continuous time, but is easier to analyze in continuous time. 14 Chapter 1 THE SOLOW GROWTH MODEL The growth rate of a variable refers to its proportional rate of change. That is, the growth rate of X refers to the quantity X˙(t )/X(t ). Thus equa- tion (1.8) implies that the growth rate of L is constant and equal to n, and (1.9) implies that A’s growth rate is constant and equal to g. A key fact about growth rates is that the growth rate of a variable equals the rate of change of its natural log. That is, Ẋ (t )/X(t ) equals d ln X(t )/dt. To see this, note that since ln X is a function of X and X is a function of t, we can use the chain rule to write d ln X(t ) d ln X(t ) dX(t ) = dt dX(t ) dt (1.10) 1 = Ẋ (t ). X(t ) Applying the result that a variable’s growth rate equals the rate of change of its log to (1.8) and (1.9) tells us that the rates of change of the logs of L and A are constant and that they equal n and g, respectively. Thus, ln L(t ) = [ln L(0)] + nt, (1.11) ln A(t ) = [ln A(0)] + gt, (1.12) where L(0) and A(0) are the values of L and A at time 0. Exponentiating both sides of these equations gives us L(t ) = L(0)e nt , (1.13) gt A(t ) = A(0)e. (1.14) Thus, our assumption is that L and A each grow exponentially.8 Output is divided between consumption and investment. The fraction of output devoted to investment, s, is exogenous and constant. One unit of output devoted to investment yields one unit of new capital. In addition, existing capital depreciates at rate δ. Thus K̇ (t ) = sY (t ) − δK (t ). (1.15) Although no restrictions are placed on n, g, and δ individually, their sum is assumed to be positive. This completes the description of the model. Since this is the first model (of many!) we will encounter, this is a good place for a general comment about modeling. The Solow model is grossly simplified in a host of ways. To give just a few examples, there is only a single good; government is absent; fluctuations in employment are ignored; production is described by an aggregate production function with just three inputs; and the rates of saving, depreciation, population growth, and tech- nological progress are constant. It is natural to think of these features of the model as defects: the model omits many obvious features of the world, 8 See Problems 1.1 and 1.2 for more on basic properties of growth rates.  1.3 The Dynamics of the Model 15 and surely some of those features are important to growth. But the purpose of a model is not to be realistic. After all, we already possess a model that is completely realistic—the world itself. The problem with that “model” is that it is too complicated to understand. A model’s purpose is to provide insights about particular features of the world. If a simplifying assump- tion causes a model to give incorrect answers to the questions it is being used to address, then that lack of realism may be a defect. (Even then, the simplification—by showing clearly the consequences of those features of the world in an idealized setting—may be a useful reference point.) If the simplification does not cause the model to provide incorrect answers to the questions it is being used to address, however, then the lack of realism is a virtue: by isolating the effect of interest more clearly, the simplification makes it easier to understand. 1.3 The Dynamics of the Model We want to determine the behavior of the economy we have just described. The evolution of two of the three inputs into production, labor and knowl- edge, is exogenous. Thus to characterize the behavior of the economy, we must analyze the behavior of the third input, capital. The Dynamics of k Because the economy may be growing over time, it turns out to be much easier to focus on the capital stock per unit of effective labor, k, than on the unadjusted capital stock, K. Since k = K /AL, we can use the chain rule to find ˙ )= K̇ (t ) K (t ) k(t − [A(t )L̇(t ) + L(t )Ȧ(t )] A(t )L(t ) [A(t )L(t )]2 (1.16) K̇ (t ) K (t ) L̇(t ) K (t ) Ȧ(t ) = − −. A(t )L(t ) A(t )L(t ) L(t ) A(t )L(t ) A(t ) K /AL is simply k. From (1.8) and (1.9), L̇ /L and Ȧ /A are n and g, respectively. K̇ is given by (1.15). Substituting these facts into (1.16) yields ˙ ) = sY (t ) − δK (t ) − k(t )n − k(t )g k(t A(t )L(t ) (1.17) Y (t ) =s − δk(t ) − nk(t ) − gk(t ). A(t )L(t ) 16 Chapter 1 THE SOLOW GROWTH MODEL Break-even investment unit of effective labor (n + g + δ)k Investment per sf (k) Actual investment k∗ k FIGURE 1.2 Actual and break-even investment Finally, using the fact that Y/AL is given by f (k), we have ˙ ) = sf (k(t )) − (n + g +δ)k(t ). k(t (1.18) Equation (1.18) is the key equation of the Solow model. It states that the rate of change of the capital stock per unit of effective labor is the difference between two terms. The first, sf (k), is actual investment per unit of effective labor: output per unit of effective labor is f (k), and the fraction of that output that is invested is s. The second term, (n + g + δ)k, is break- even investment, the amount of investment that must be done just to keep k at its existing level. There are two reasons that some investment is needed to prevent k from falling. First, existing capital is depreciating; this capital must be replaced to keep the capital stock from falling. This is the δk term in (1.18). Second, the quantity of effective labor is growing. Thus doing enough investment to keep the capital stock (K ) constant is not enough to keep the capital stock per unit of effective labor (k) constant. Instead, since the quantity of effective labor is growing at rate n + g, the capital stock must grow at rate n + g to hold k steady.9 This is the (n + g)k term in (1.18). When actual investment per unit of effective labor exceeds the invest- ment needed to break even, k is rising. When actual investment falls short of break-even investment, k is falling. And when the two are equal, k is constant. Figure 1.2 plots the two terms of the expression for k˙ as functions of k. Break-even investment, (n + g+δ)k, is proportional to k. Actual investment, sf (k), is a constant times output per unit of effective labor. Since f (0) = 0, actual investment and break-even investment are equal at k = 0. The Inada conditions imply that at k = 0, f  (k) is large, and thus that the sf (k) line is steeper than the (n + g + δ)k line. Thus for small values of 9 The fact that the growth rate of the quantity of effective labor, AL, equals n + g is an instance of the fact that the growth rate of the product of two variables equals the sum of their growth rates. See Problem 1.1.  1.3 The Dynamics of the Model 17. k 0 k k∗ FIGURE 1.3 The phase diagram for k in the Solow model k, actual investment is larger than break-even investment. The Inada con- ditions also imply that f  (k) falls toward zero as k becomes large. At some point, the slope of the actual investment line falls below the slope of the break-even investment line. With the sf (k) line flatter than the (n + g + δ)k line, the two must eventually cross. Finally, the fact that f  (k) < 0 implies that the two lines intersect only once for k > 0. We let k ∗ denote the value of k where actual investment and break-even investment are equal. Figure 1.3 summarizes this information in the form of a phase diagram, which shows k˙ as a function of k. If k is initially less than k ∗ , actual in- vestment exceeds break-even investment, and so k˙ is positive—that is, k is rising. If k exceeds k ∗ , k˙ is negative. Finally, if k equals k ∗ , then k˙ is zero. Thus, regardless of where k starts, it converges to k ∗ and remains there.10 The Balanced Growth Path Since k converges to k ∗ , it is natural to ask how the variables of the model behave when k equals k ∗. By assumption, labor and knowledge are growing at rates n and g, respectively. The capital stock, K , equals ALk; since k is constant at k ∗ , K is growing at rate n + g (that is, K̇ /K equals n + g). With both capital and effective labor growing at rate n + g, the assumption of constant returns implies that output, Y, is also growing at that rate. Finally, capital per worker, K /L, and output per worker, Y/L, are growing at rate g. 10 If k is initially zero, it remains there. However, this possibility is ruled out by our assumption that initial levels of K , L, and A are strictly positive. 18 Chapter 1 THE SOLOW GROWTH MODEL Thus the Solow model implies that, regardless of its starting point, the economy converges to a balanced growth path—a situation where each variable of the model is growing at a constant rate. On the balanced growth path, the growth rate of output per worker is determined solely by the rate of technological progress.11 1.4 The Impact of a Change in the Saving Rate The parameter of the Solow model that policy is most likely to affect is the saving rate. The division of the government’s purchases between consump- tion and investment goods, the division of its revenues between taxes and borrowing, and its tax treatments of saving and investment are all likely to affect the fraction of output that is invested. Thus it is natural to investigate the effects of a change in the saving rate. For concreteness, we will consider a Solow economy that is on a balanced growth path, and suppose that there is a permanent increase in s. In addition to demonstrating the model’s implications concerning the role of saving, this experiment will illustrate the model’s properties when the economy is not on a balanced growth path. The Impact on Output The increase in s shifts the actual investment line upward, and so k ∗ rises. This is shown in Figure 1.4. But k does not immediately jump to the new value of k ∗. Initially, k is equal to the old value of k ∗. At this level, actual investment now exceeds break-even investment—more resources are being devoted to investment than are needed to hold k constant—and so k˙ is positive. Thus k begins to rise. It continues to rise until it reaches the new value of k ∗ , at which point it remains constant. These results are summarized in the first three panels of Figure 1.5. t 0 de- notes the time of the increase in the saving rate. By assumption, s jumps up 11 The broad behavior of the U.S. economy and many other major industrialized economies over the last century or more is described reasonably well by the balanced growth path of the Solow model. The growth rates of labor, capital, and output have each been roughly constant. The growth rates of output and capital have been about equal (so that the capital-output ratio has been approximately constant) and have been larger than the growth rate of labor (so that output per worker and capital per worker have been rising). This is often taken as evidence that it is reasonable to think of these economies as Solow-model economies on their balanced growth paths. Jones (2002a) shows, however, that the underlying determi- nants of the level of income on the balanced growth path have in fact been far from constant in these economies, and thus that the resemblance between these economies and the bal- anced growth path of the Solow model is misleading. We return to this issue in Section 3.3.  1.4 The Impact of a Change in the Saving Rate 19 (n + g + δ)k Investment per unit of effective labor s NEWf (k) s OLDf (k) k ∗OLD k ∗NEW k FIGURE 1.4 The effects of an increase in the saving rate on investment at time t 0 and remains constant thereafter. Since the jump in s causes actual investment to exceed break-even investment by a strictly positive amount, k˙ jumps from zero to a strictly positive amount. k rises gradually from the old value of k ∗ to the new value, and k˙ falls gradually back to zero.12 We are likely to be particularly interested in the behavior of output per worker, Y/L. Y/L equals A f (k). When k is constant, Y/L grows at rate g, the growth rate of A. When k is increasing, Y/L grows both because A is increasing and because k is increasing. Thus its growth rate exceeds g. When k reaches the new value of k ∗ , however, again only the growth of A contributes to the growth of Y/L, and so the growth rate of Y/L returns to g. Thus a permanent increase in the saving rate produces a temporary increase in the growth rate of output per worker: k is rising for a time, but eventually it increases to the point where the additional saving is devoted entirely to maintaining the higher level of k. The fourth and fifth panels of Figure 1.5 show how output per worker responds to the rise in the saving rate. The growth rate of output per worker, which is initially g, jumps upward at t0 and then gradually returns to its initial level. Thus output per worker begins to rise above the path it was on and gradually settles into a higher path parallel to the first.13 12 For a sufficiently large rise in the saving rate, k̇ can rise for a while after t 0 before starting to fall back to zero. 13 Because the growth rate of a variable equals the derivative with respect to time of its log, graphs in logs are often much easier to interpret than graphs in levels. For example, if a variable’s growth rate is constant, the graph of its log as a function of time is a straight line. This is why Figure 1.5 shows the log of output per worker rather than its level. 20 Chapter 1 THE SOLOW GROWTH MODEL s t0 t. k 0 t0 t k t0 t Growth rate of Y/L g t0 t ln(Y/L) t0 t c t0 t FIGURE 1.5 The effects of an increase in the saving rate In sum, a change in the saving rate has a level effect but not a growth effect: it changes the economy’s balanced growth path, and thus the level of output per worker at any point in time, but it does not affect the growth rate of output per worker on the balanced growth path. Indeed, in the  1.4 The Impact of a Change in the Saving Rate 21 Solow model only changes in the rate of technological progress have growth effects; all other changes have only level effects. The Impact on Consumption If we were to introduce households into the model, their welfare would de- pend not on output but on consumption: investment is simply an input into production in the future. Thus for many purposes we are likely to be more interested in the behavior of consumption than in the behavior of output. Consumption per unit of effective labor equals output per unit of effec- tive labor, f (k), times the fraction of that output that is consumed, 1 − s. Thus, since s changes discontinuously at t0 and k does not, initially con- sumption per unit of effective labor jumps downward. Consumption then rises gradually as k rises and s remains at its higher level. This is shown in the last panel of Figure 1.5. Whether consumption eventually exceeds its level before the rise in s is not immediately clear. Let c ∗ denote consumption per unit of effective labor on the balanced growth path. c ∗ equals output per unit of effective labor, f (k ∗ ), minus investment per unit of effective labor, sf (k ∗ ). On the balanced growth path, actual investment equals break-even investment, (n + g+δ)k ∗. Thus, c ∗ = f (k ∗ ) − (n + g + δ)k ∗. (1.19) k ∗ is determined by s and the other parameters of the model, n, g, and δ; we can therefore write k ∗ = k ∗ (s, n, g, δ). Thus (1.19) implies ∂c ∗ ∂k ∗ (s, n, g, δ) = [ f  (k ∗ (s, n, g, δ)) − (n + g + δ)]. (1.20) ∂s ∂s We know that the increase in s raises k ∗ ; that is, we know that ∂k ∗ /∂s is positive. Thus whether the increase raises or lowers consumption in the long run depends on whether f  (k ∗ )—the marginal product of capital—is more or less than n + g +δ. Intuitively, when k rises, investment (per unit of effective labor) must rise by n + g + δ times the change in k for the increase to be sustained. If f  (k ∗ ) is less than n + g + δ, then the additional output from the increased capital is not enough to maintain the capital stock at its higher level. In this case, consumption must fall to maintain the higher capital stock. If f  (k ∗ ) exceeds n + g + δ, on the other hand, there is more than enough additional output to maintain k at its higher level, and so con- sumption rises. f  (k ∗ ) can be either smaller or larger than n + g + δ. This is shown in Figure 1.6. The figure shows not only (n + g + δ)k and sf (k), but also f (k). Since consumption on the balanced growth path equals output less break- even investment (see [1.19]), c ∗ is the distance between f (k) and (n + g + δ)k at k = k ∗. The figure shows the determinants of c ∗ for three different values 22 Chapter 1 THE SOLOW GROWTH MODEL f (k ) per unit of effective labor Output and investment (n + g + δ)k sH f (k) ∗ kH k f (k) per unit of effective labor Output and investment (n + g + δ)k sLf (k) k L∗ k f (k) per unit of effective labor Output and investment (n + g + δ)k sMf (k) k∗ M k FIGURE 1.6 Output, investment, and consumption on the balanced growth path  1.5 Quantitative Implications 23 of s (and hence three different values of k ∗ ). In the top panel, s is high, and so k ∗ is high and f  (k ∗ ) is less than n + g + δ. As a result, an increase in the saving rate lowers consumption even when the economy has reached its new balanced growth path. In the middle panel, s is low, k ∗ is low, f  (k ∗ ) is greater than n + g + δ, and an increase in s raises consumption in the long run. Finally, in the bottom panel, s is at the level that causes f  (k ∗ ) to just equal n + g + δ—that is, the f (k) and (n + g + δ)k loci are parallel at k = k ∗. In this case, a marginal change in s has no effect on consumption in the long run, and consumption is at its maximum possible level among balanced growth paths. This value of k ∗ is known as the golden-rule level of the capital stock. We will discuss the golden-rule capital stock further in Chapter 2. Among the questions we will address are whether the golden-rule capital stock is in fact desirable and whether there are situations in which a decentralized economy with endogenous saving converges to that capital stock. Of course, in the Solow model, where saving is exogenous, there is no more reason to expect the capital stock on the balanced growth path to equal the golden- rule level than there is to expect it to equal any other possible value. 1.5 Quantitative Implications We are usually interested not just in a model’s qualitative implications, but in its quantitative predictions. If, for example, the impact of a moderate increase in saving on growth remains large after several centuries, the result that the impact is temporary is of limited interest. For most models, including this one, obtaining exact quantitative results requires specifying functional forms and values of the parameters; it often also requires analyzing the model numerically. But in many cases, it is possi- ble to learn a great deal by considering approximations around the long-run equilibrium. That is the approach we take here. The Effect on Output in the Long Run The long-run effect of a rise in saving on output is given by ∂y ∗ ∂k ∗ (s, n, g, δ) = f  (k ∗ ) , (1.21) ∂s ∂s where y ∗ = f (k ∗ ) is the level of output per unit of effective labor on the balanced growth path. Thus to find ∂y ∗/∂s, we need to find ∂k ∗/∂s. To do this, note that k ∗ is defined by the condition that k˙ = 0. Thus k ∗ satisfies sf (k ∗ (s, n, g, δ)) = (n + g + δ)k ∗ (s, n, g, δ). (1.22) 24 Chapter 1 THE SOLOW GROWTH MODEL Equation (1.22) holds for all values of s (and of n, g, and δ). Thus the deriva- tives of the two sides with respect to s are equal:14 ∂k ∗ ∂k ∗ sf  (k ∗ ) + f (k ∗ ) = (n + g + δ) , (1.23) ∂s ∂s where the arguments of k ∗ are omitted for simplicity. This can be rearranged to obtain15 ∂k ∗ f (k ∗ ) =. (1.24) ∂s (n + g + δ) − sf  (k ∗ ) Substituting (1.24) into (1.21) yields ∂y ∗ f  (k ∗ ) f (k ∗ ) =. (1.25) ∂s (n + g + δ) − sf  (k ∗ ) Two changes help in interpreting this expression. The first is to convert it to an elasticity by multiplying both sides by s/y ∗. The second is to use the fact that sf (k ∗ ) = (n + g + δ)k ∗ to substitute for s. Making these changes gives us s ∂y ∗ s f  (k ∗ ) f (k ∗ ) ∗ = y ∂s f (k ) (n + g + δ) − sf  (k ∗ ) ∗ (n + g + δ)k ∗f  (k ∗ ) = (1.26) f (k ∗ )[(n + g + δ) − (n + g + δ)k ∗ f  (k ∗ )/f (k ∗ )] k ∗ f  (k ∗ )/f (k ∗ ) =. 1 − [k ∗f  (k ∗ )/f (k ∗ )] k ∗f  (k ∗ )/f (k ∗ ) is the elasticity of output with respect to capital at k = k ∗. Denoting this by αK (k ∗ ), we have s ∂y ∗ αK (k ∗ ) ∗ =. (1.27) y ∂s 1 − αK (k ∗ ) Thus we have found a relatively simple expression for the elasticity of the balanced-growth-path level of output with respect to the saving rate. To think about the quantitative implications of (1.27), note that if mar- kets are competitive and there are no externalities, capital earns its marginal 14 This technique is known as implicit differentiation. Even though (1.22) does not ex- plicitly give k ∗ as a function of s, n, g, and δ, it still determines how k ∗ depends on those variables. We can therefore differentiate the equation with respect to s and solve for ∂k ∗/∂s. 15 We saw in the previous section that an increase in s raises k ∗. To check that this is also implied by equation (1.24), note that n + g + δ is the slope of the break-even investment line and that sf  (k ∗ ) is the slope of the actual investment line at k ∗. Since the break-even investment line is steeper than the actual investment line at k ∗ (see Figure 1.2), it follows that the denominator of (1.24) is positive, and thus that ∂k ∗/∂s > 0.  1.5 Quantitative Implications 25 product. Since output equals ALf (k) and k equals K /AL, the marginal prod- uct of capital, ∂Y/∂K , is ALf  (k)[1/(AL)], or just f  (k). Thus if capital earns its marginal product, the total amount earned by capital (per unit of effective labor) on the balanced growth path is k ∗f  (k ∗ ). The share of total income that goes to capital on the balanced growth path is then k ∗f  (k ∗ )/f (k ∗ ), or αK (k ∗ ). In other words, if the assumption that capital earns its marginal product is a good approximation, we can use data on the share of income going to capital to estimate the elasticity of output with respect to capital, αK (k ∗ ). In most countries, the share of income paid to capital is about one-third. If we use this as an estimate of αK (k ∗ ), it follows that the elasticity of output with respect to the saving rate in the long run is about one-half. Thus, for example, a 10 percent increase in the saving rate (from 20 percent of output to 22 percent, for instance) raises output per worker in the long run by about 5 percent relative to the path it would have followed. Even a 50 percent increase in s raises y ∗ only by about 22 percent. Thus significant changes in saving have only moderate effects on the level of output on the balanced growth path. Intuitively, a small value of αK (k ∗ ) makes the impact of saving on output low for two reasons. First, it implies that the actual investment curve, sf (k), bends fairly sharply. As a result, an upward shift of the curve moves its intersection with the break-even investment line relatively little. Thus the impact of a change in s on k ∗ is small. Second, a low value of αK (k ∗ ) means that the impact of a change in k ∗ on y ∗ is small. The Speed of Convergence In practice, we are interested not only in the eventual effects of some change (such as a change in the saving rate), but also in how rapidly those effects occur. Again, we can use approximations around the long-run equilibrium to address this issue. For simplicity, we focus on the behavior of k rather than y. Our goal is thus to determine how rapidly k approaches k ∗. We know that k˙ is determined by k: recall that the key equation of the model is k˙ = sf (k) − (n + g + δ)k (see [1.18]). Thus we can write k˙ = k(k). ˙ When k equals k ∗ , k˙ is zero. A first- order Taylor-series approximation of k(k) around k = k ∗ therefore yields ˙    ˙  ∂k(k) k˙   (k − k ∗ ). (1.28) ∂k  k=k ∗ That is, k˙ is approximately equal to the product of the difference between k and k ∗ and the derivative of k˙ with respect to k at k = k ∗. ˙ Let λ denote −∂k(k)/∂k |k=k ∗. With this definition, (1.28) becomes ˙ )  −λ[k(t ) − k ∗ ]. k(t (1.29) 26 Chapter 1 THE SOLOW GROWTH MODEL Since k˙ is positive when k is slightly below k ∗ and negative when it is slightly ˙ above, ∂k(k)/∂k |k=k ∗ is negative. Equivalently, λ is positive. Equation (1.29) implies that in the vicinity of the balanced growth path, k moves toward k ∗ at a speed approximately proportional to its distance from k ∗. That is, the growth rate of k(t ) − k ∗ is approximately constant and equal to −λ. This implies k(t )  k ∗ + e −λt [k(0) − k ∗ ], (1.30) where k(0) is the initial value of k. Note that (1.30) follows just from the facts that the system is stable (that is, that k converges to k ∗ ) and that we are linearizing the equation for k˙ around k = k ∗. It remains to find λ; this is where the specifics of the model enter the anal- ysis. Differentiating expression (1.18) for k˙ with respect to k and evaluating the resulting expression at k = k ∗ yields   ˙  ∂k(k) λ≡ −  = −[sf  (k ∗ ) − (n + g + δ)] ∂k  k=k ∗ = (n + g + δ) − sf  (k ∗ ) (1.31) (n + g + δ)k ∗f  (k ∗ ) = (n + g + δ) − f (k ∗ ) = [1 − αK (k ∗ )](n + g + δ). Here the third line again uses the fact that sf (k ∗ ) = (n + g + δ)k ∗ to sub- stitute for s, and the last line uses the definition of αK. Thus, k converges to its balanced-growth-path value at rate [1 − αK (k ∗ )](n + g +δ). In addition, one can show that y approaches y ∗ at the same rate that k approaches k ∗. That is, y (t ) − y ∗  e −λt [y (0) − y ∗ ].16 We can calibrate (1.31) to see how quickly actual economies are likely to approach their balanced growth paths. Typically, n + g+δ is about 6 percent per year. This arises, for example, with 1 to 2 percent population growth, 1 to 2 percent growth in output per worker, and 3 to 4 percent depreciation. If capital’s share is roughly one-third, (1 − αK )(n + g + δ) is thus roughly 4 percent. Therefore k and y move 4 percent of the remaining distance toward k ∗ and y ∗ each year, and take approximately 17 years to get halfway to their balanced-growth-path values.17 Thus in our example of a 10 percent 16 See Problem 1.11. 17 The time it takes for a variable (in this case, y − y ∗ ) with a constant negative growth rate to fall in half is approximately equal to 70 divided by its growth rate in percent. (Similarly, the doubling time of a variable with positive growth is 70 divided by the growth rate.) Thus in this case the half-life is roughly 70/(4%/year), or about 17 years. More exactly, the half-life, ∗ t ∗ , is the solution to e −λt = 0.5, where λ is the rate of decrease. Taking logs of both sides, t ∗ = − ln(0.5)/λ  0.69/λ.  1.6 The Solow Model and the Central Questions of Growth Theory 27 increase in the saving rate, output is 0.04(5%) = 0.2% above its previous path after 1 year; is 0.5(5%) = 2.5% above after 17 years; and asymptotically approaches 5 percent above the previous path. Thus not only is the overall impact of a substantial change in the saving rate modest, but it does not occur very quickly.18 1.6 The Solow Model and the Central Questions of Growth Theory The Solow model identifies two possible sources of variation—either over time or across parts of the world—in output per worker: differences in c