Growth Models

In session 3 we use the Solow growth model to help collect thoughts about the long-run dynamics of a competitive market economy. The implicit assumption is one of efficient firms operating at the production frontier. The model tells us that net investment adds to the capital stock which, in turn, adds to GDP. We abstract from pesky external and government sectors, ignore inflation and sweep finance under the carpet. Unemployment and under-utilisation of capital do not figure in our stories. And the emphasis is on smooth, continuous waves – no stochastics, small or epic, allowed!

Like all models it is both wrong and useful. Immensely instructive as a pedagogical tool but also glossing over too many harsh realities to carry us through this course. But we have to start somewhere and, at the very least, it will help exercise some maths muscles before we tackle thornier issues such as stagnation (slower trend growth), distribution (what growth there is seems unfairly spread), imperfect competition, radical uncertainty together with the mysteries of money and banking.

Please do not forget the lessons learnt in our first two sessions. Advanced economies are increasingly “intangible” in their production focus. This makes it very hard not just to measure what is going on with productivity but also whether growth disappointments really matter for society’s well-being.

That said, we shall take time to look at US data comparing the last 15 or so years with the half-century preceding it. The comparisons do not make for comfortable reading. Trend GDP growth has more than halved, despite all the techno-hype. Ok, part of it is a slowdown in the growth of the labour force. But digging deeper shows that total factor productivity (TFP) growth has more than halved. 

We shall need to do algebra so make sure you dust off your notes on exponentials, natural logarithms and calculus. Hopefully, the colour-coordinated slides, cheat sheets and Excel playbooks will dull any pain.  We identify the links between so-called Loanable Funds analysis (presumably covered in your Principles course) and introduce a core concept in Intermediate Macroeconomics, namely R-Star.

R-Star is the long-equilibrium (or “natural”) real interest rate and, like growth and productivity, has displayed an unnerving slide in recent years. We shall come across R-Star many times through this course. For example, evidence that it has slumped to around zero (and the US is not alone) is creating huge headaches for central banks. As if financial crises and pandemics were not enough! 

Along the way we shall question many of the key assumptions of the Solow model. The idea that we live in perfectly competitive factor markets stretches credulity. And the exogeneity of total factor productivity is also problematic. We shall note that modern macroeconomists are taking such “defects” on board – the Romer model which introduces a distinction between ideas and objects is particularly instructive. But time is limited so we focus on basics whilst recognising that we can do better once we have mastered the essentials.

A key takeaway is that the mathematics of the Solow model should not blind us to the deeply political issues that supply-side macro touches on. Classical Economists such as Mill, Smith, Marx and Ricardo were fully aware that commerce does not exist in an institutional vacuum. We illustrate all that, albeit sketchily, by seeking to apply our basic Solow apparatus to explore topics such as immigration, climate change and pandemics.

11 Feb 2021