Transcript Lecture 2 & 3

Topic 1: Ireland’s long-run
economic performance

Readings

Abel & Bernanke or other macro textbook
 Chapter

on long-run economic growth
Solow model and convergence

Honohan and Walsh (2002)

Blanchard (2002)
The Solow Growth Model
Also known as the “neoclassical” growth model
Interactive experiments available at:
http://www.fgn.unisg.ch/eurmacro/tutor/solow_index.html
Cobb-Douglas production
function
Y = A F(K, L) = A Ka L(1-a)
Y = Output
A = Total Factor Productivity (TFP)
K = Capital input
L = Labour input
TFP (A)


A: Also called the “Solow residual”
Captures wide range of factors:





State of technology
Strength of economic and political institutions
Input utilization
Sectoral composition of output
Other stuff
Sectoral composition of output


A = economy-wide level of productivity
Consider an economy with two sectors:



1. Agriculture = low productivity
2. Manufacturing = high productivity
If Agriculture shrinks and Manufacturing
grows, then A increases
a = elasticity of Y w.r.t. K

Exercise 1: Prove it!
Also:
a = capital’s share of output (1<a<0)

Exercise 2: Prove it!
Per worker version
divide by L
y = Af(k) = A ka
where
y = Y/L
k = K/L
Exercise 3: Prove it!
Law of motion for the capital stock:
kt+1 = (1-d) kt + it
Where:
i = investment
d = rate of depreciation
What happens to the capital stock if
it = dkt
kt+1 = (1-d) kt + it
kt+1 = kt - dkt + it
kt+1 = kt
Let k* = steady-state capital stock
y* = Af(k*) = steady-state output
If it > dkt then capital stock is growing
If it < dkt then capital stock is shrinking
In a closed economy:
Investment = Savings
i = sy
i = sAf(k)
where s = savings rate
Convergence

Conditional convergence




If two countries have the similar A and s, but
different initial k, then they will converge
If a SOE, then s not important
Absent obstacles, A’s shouldn’t be very
different across advanced economies
Evidence of conditional convergence
among advanced economies
Honohan and Walsh (2002)

1990s boom was a convergence story



Convergence telescoped into one decade
No single factor accounts for 1990s boom
Why didn’t Ireland converge sooner?

Institutional preconditions for such
convergence already present in 1973, but
fiscal policy errors in the 1970s derailed
convergence
Honohan and Walsh (2002)

Why was convergence in the 1990s so
rapid?

How do we explain the employment boom?
Non-agricultural employment as
share of population
40
35
30
25
20
60
65
70
75
80
85
90
Source: Honohan and Walsh (2002)
95
00
Table 1: Ireland’s employment share and productivity relative to UK, 1973
Ireland
UK
Ireland
As % of UK
Apparent Productivity (£ per head)
GDP per person at work
Agricultural output per person at work
Non-agricultural output per person at work
GDP per head of population
2 380
1 634
2 605
856
2 642
2 726
2 640
1 173
90
60
99
73
Employment shares (%)
Employment in agriculture as % total
Total employment as % population
Non-agricultural employment as % population
23.2
36.0
27.6
3.0
44.4
43.1
780
81
64
Source: Ireland: ESRI database; UK: Annual Abstract of Statistics, 1985 edition; OECD National Income
Accounts. Note: “Agriculture” includes forestry and fisheries. The difference between GDP and GNP in
1973 was small.
Source: Honohan and Walsh (2002)
Fiscal Errors


See Figure 3: Budgetary Aggregates
See Figure 4: Marginal and Average
Income Tax Rates, 1979-2002
Unfavorable external conditions
Table 2: External conditions in the 1980s
UK GDP Growth
% per annum
US $ short interest
rate
%
1981-84
1.8
12.0
1986-89
4.1
7.6
Source: Honohan and Walsh (2002)
Blanchard (2002)
•
•
•
Key factor behind boom: Wage
moderation
Wage moderation = “wage growth below
the rate consistent with technological
progress.”
Low wage growth  lower costs  higher
profits  higher K and L
Blanchard (2002)
Recall: Y = A F(K, L) = A Ka L(1-a)


Marginal product of labour (MPL)
MPL = DY/DL = (1-a)A F(K, L)/L
From micro, we know that firms choose L
to equate the MPL to the market wage
rate
So, for the whole economy:
w = (1-a)A F(K, L)/L
w/A = (1-a) F(K, L)/L
w/A = (1-a) (K/L)a
 Exercise 4: Prove it!
 If w/A falls, then
K/L must fall
 But K rises due to higher profits
 So L must boom!

So wage restraint boosts investment
and especially employment

Sources of wage restraint
 Social partnership agreements
 High unemployment
 Natural demographics
 Immigration
 Income tax cuts

Why did wage moderation have such
a large effect in Ireland?
 Openness of economy
amount of  K took the form
of Foreign Direct Investment (FDI)
 Migration flows
 Available export markets
 Notable
 No
“crowding out”

Reading for next lecture
 Ahearne, Kydland, and Wynne (2005)
 Barry (2002)
 Fitz Gerald (2004)