## Economics of EU Integration Lecture 5

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Assuming an EMU, what are the economic effects of one? We saw last week that the EU was almost certainly not and OCA, yet the EU exists as a functioning currency area. What are the likely effects of this on growth amongst member states? We developed the canonical model used to describe economic growth, and expose this model to the facts. We also looked at capital and factor market integration.

Here are the lecture notes, here is the handout. A recording of the lecture is below.

## Economics for Business Lecture 17

In the last few lectures, we've looked at growth theory and the stakes involved in getting the basics wrong. We saw the Solow model's predictions about sustained capital accumulation ($\Delta k/k$): keep population growth low, keep savings ($s$) and therefore investment($I$) rather high, and try to curb depreciation on assets. Technical progress and human capital move the economy forward, potentially stimulating convergence of growth rates.

Now we'll move onto a micro-founded macro model developed in the later chapters of the Barro book. The basic idea is to specify four markets inside the economy: the products market, the bond market, the money market, and the labour market. We'll build our macroeconomic equilibria from behavioural assumptions about the actors in the model: households and firms. Households are assumed to want to maximise their incomes from all of these markets, subject to a budget constraint. Firms want to maximise profits. Their interactions, along with the usual macroeconomic accounting identities, such as $Y=C+I+G$, give us the macroeconomic equilibrium, called a general equilibrium.

Click the link below to download slides, handouts, etc.

Click the link below to download papers and interviews about growth, technical progress, and the micro-founded macro model.

## Economics for Business Lecture 16: Growth and Convergence

Why are we so rich and they so poor? This is the fundamental question in macroeconomics. Economists agree that the main way to enrich a country and its people is to create the conditions which allow it to grow its way out of poverty. By growth, I mean GDP growth of course.

We have seen in the last few lectures that the determinants of GDP growth are increases in the rate of capital accumulation through saving and investment, increasing rates of technological change, and a steady population growth rate.

Now we'll look at the predictions of the Solow growth model and it's extensions while asking how much the theory actually explains when we look at the data.

The Solow model predicts that growth rates tend to diminish over time as the economy approaches a steady state level of output per worker. The steady state level of output per worker is shown to increase as savings rates or technology increase. The steady state level of output per worker falls as the population or grows.

Changes to the labour force can affect the growth rate because they change the capital labour ratio, but they do not affect the ultimate steady state level of output per worker. In all of these cases, the curves in the basic steady state diagram are shifted to illustrate the effects of changing parameter values on the steady state level of capital.

Following a quick recap (for the five or six of you that didn't make it), we'll examine the concept of absolute convergence next. Since the rate of capital accumulation per worker is essentially determined by the current stock of capital per worker, lesser developed countries are predicted by the model to grow more quickly than developed countries. However, the capital per worker will only generate faster growth rates if the values of the other parameters (savings, technology, population growth, etc.) are somewhat comparable. This implies that there is only conditional convergence.

We'll look at the data, talk about growth and convergence across the world.

Oh, and there will be a quiz in class.

Click the link below for slides, a handout version of the slides, and links to interesting articles.

## Economics for Business Lecture 15: Growth Models

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The Solow Growth model attempts to explain the features of growth we encountered in the last lecture. We need to be able to explain movements in capital accumulation, labour force growth, and technology.

Beginning from the growth accounting equation

$\frac{\Delta Y}{Y} = \frac{\Delta A}{A} + \alpha \cdot \frac{\Delta K}{K} + (1-\alpha)\frac{\Delta L}{L}$

and simplifying the notation to look at accumulation in per worker  ($y = Y/L$, etc) terms with no technological change, we should see that the growth rate of real GDP per worker will be the difference between the growth rate of real GDP and the growth rate of labour, because of diminishing marginal productivity of labour. In our notation,

$\frac{\Delta y}{y} = \frac{\Delta Y}{Y} - \frac{\Delta L}{L}$

And using the same idea, we can show

$\frac{\Delta k}{k} = \frac{\Delta K}{K} - \frac{\Delta L}{L}$.

The equation above just says the growth rate of capital per worker is equal to the growth rate of capital minus the growth rate of labour.

Rearranging our first equation above using the new identities, we get

$\frac{\Delta Y}{Y} - \frac{\Delta L}{L} = \alpha \cdot \left( \frac{\Delta K}{K} - \frac{\Delta L}{L} \right)$

But we know that in per worker terms, we can reduce this equation to

$\frac{\delta y}{y} = \alpha \cdot \frac{\Delta k}{k}$

The growth of real GDP per worker depends only on the growth rate of capital per worker.

So, Solow says we should spend time thinking about policies to increase the growth rate of capital per worker in an economy in order to develop.

Solow Lesson 1: Focus on growth rate of capital per worker, $\Delta k/k$.

How does the growth rate of capital change?

The growth rate of the capital stock depends on how much the economy saves. This is because, in the medium term, everything saved gets invested. Real income in the macroeconomy must equal the Net Domestic Product, which is GDP taking depreciation ($\delta$) of the capital stock, $K$, into account. We can define real saving as the saving rate times the level of real income, or

Real Saving = $s \cdot (Y - \delta K)$

We know that household income equals the sum of what gets consumed and what gets saved, so the following equation must be true:

$Y - \delta K = C + s \cdot (Y - \delta K)$

And, because in macroeconomic equilibrium savings will always equal net investment, we can say

$Y - \delta K = C + (I + \delta K)$.

The change in capital stock will equal gross investment (that $I$ in the equation above), so we can write

$s \cdot (Y - \delta K) = I - \delta K$, and then because the change in the capital stock will equal gross investment minus depreciation of the capital stock, we have something like

$\Delta K = s \cdot (Y - \delta K)$.

Which in per worker terms, after some rearranging, which we'll do in class, is

$\Delta k/k = \Delta K / K - \Delta L / L$.

Combine this result with the requirement that the growth rate of labour should be constant, or

$\frac{\Delta L}{L} = n$

to get the result that the growth rate of capital per worker is dependent on the amount saved out of output per worker minus the cost of replacing depreciated capital per year minus the labour force growth rate, and we have

$\frac{\Delta k}{k} - s \cdot (\frac{y}{k}) - s\delta - n$.

Reversing this equation and plugging in the value for the growth rate of capital per worker, we have

$\frac{\Delta y}{y} = \alpha \cdot [s \cdot (\frac{y}{k})-s \delta - n]$.

Phew! That was a bit of a struggle, but don't worry, we'll go through some numerical examples tomorrow. You can also download the slides and a podcast after the lecture.

You really should read Barro, chapters 3 and 4, to understand this material deeply.

## Economics for Business Lecture 14

Last week we looked at the scope of macroeconomics, albeit quite briefly. This week we'll get into some national accounts and growth questions. We'll talk about the main questions in growth theory, motivate it with an example, and discuss the macroeconomic particulars a theory of growth and development has to explain. It's always useful to begin with a story. Argentina in 1900 was the richest country in the world. A series of macroeconomic downturns culminated in the banking crisis from 1999 to 2002. Here's a quote from one of the people who had to live through this period:

"You know, we're not used to this, not having enough food," said Orresta, with a hint of embarrassment in her voice.
She paused, and began to weep.
"You can't know what it's like to see your children hungry and feel helpless to stop it," she said.
"The food is there, in the grocery store, but you just can't afford to buy it anymore. My husband keeps working, but he keeps bringing home less and less. We never had much, but we always had food, no matter how bad things got. But these are not normal times."

In the second half of this course, you will be exposed to models of the macroeconomy---the study of the aggregated actions of households, firms, government, and other economic actors in society. We'll look at the national accounts, how fluctuations in the economy are measured, look at some of these measurements, and talk a little about economic growth through the story of Ireland. That's the topic for this lecture. The important thing to remember from this lecture is: growth matters.

What is the macroeconomy?

The economy can be thought of as a productive engine. It takes raw materials like land, and physical capital, and combined with
labour (physical labour and skilled labour) and a little enterprising entrepreneurship, produces goods and services. These goods and services add to the stock of goods and services already produced in years past, and the economy is said to grow by the amount produced in the economy.

Definition 1 (The MacroeconomyThe macroeconomy is a machine for producing goods and services.

How do we measure the macroeconomy?

When we discuss the macroeconomy, we need to talk about aggregated variables. Aggregated variables are the sums of individual variables. For example, total private consumption in an economy over a period of time, $C$, is the sum of all the goods and services consumed in the economy by households in a given period, say, a year.

We also talk about the relationships between those aggregated variables. We don't really know these relationships, so we invent a story about them. These stories are called models.

Definition 2. (Models) Macroeconomic models are stories about how one or more aggregate variable affects another.

Growth rates

We can calculate the growth rate of the economy by calculating the gross domestic product of the economy from year to year and getting their relationship.

Definition 3 (GDP) The gross domestic product (GDP) is the sum of all final goods and services produced in the economy in a given year.
The GDP growth of an economy can be measured by

GDP Growth = GDP_(t)-GDP_(t-1)/GDP_(t-1) * 100

So, for example, if GDP in 2006 was 105, and GDP in 2005 was 100, the growth rate of GDP would be ((GDP_{2006}-GDP_{2005})/GDP_{2005}-1)*100=((105-100)/100-1)*100=5\%.

Measuring the Macroeconomy

We'll spend some time looking at Ireland's National Accounts, because through them we can gauge how well the economy is doing.

Then we'll talk about economic growth. You've already seen that growth matters in  the last lecture, but this time we'll go through a model, called the Solow model, which explains how economies grow, when they don't, and when they do.

In this lecture, we'll study the case of Argentina in the 1990's. You can see from Gapminder that Argentina has had a rough ride in terms of GDP per capita over the last 50 years. We will see examples of this in the lecture.

## McWilliams hits the nail on the head on Irish Credit Crunch Solution

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David McWilliams, echoing Martin Feldstein in the FT earlier this week, suggests a Central Bank refinancing of banks to introduce liquidity into the system using the fact we are in an economic and monetary union. McWilliams' sense of social justice ensures the developers, whom he blames for the present mess (and he's not too far wrong there) will get short shrift from this deal. This is an excellent idea from McWilliams.

The key insight of the post is that EMU is not just a set of constraints on monetary policy---it is also an opportunity to provide free liquidity, at least on the relatively small scale Ireland would require.

McWilliams tells us, in a lovely turn of phrase:

Monetary union is a two-way street. While we can’t affect our interest rates, we can engineer liquidity.

A longer post on this when I start teaching Economics of EU Integration in a few weeks.