Economics 202ALecture #1 Outline (version 2.0)Maurice ObstfeldAbout This CourseThe …rst part of this course will focus on long-run macro questions, withmuch of the discussion of short-term ‡uctuations and the business cycle heldo¤ until Economics 202B in the spring.Thus, we begin by covering various issues in economic growth theory, thebasics of consumption and investment theory, the fundamentals asset pricing,and the long-run linkage between money and the price level.We will depart from this long-run emphasis toward the end of the semesterwhen we discuss informational frictions in …nancial markets, the dynamicconsistency problem in monetary policy, banking instability and (if we getthat far), labor markets.We start o¤ by tackling four issues relating to long-term economic growth:1. The connections among saving, (exogenous) technology improvements,long-run capital intensity, and long-run per capita income, as recountedby the famous model of Solow (1956).2. The implications of forward-looking consumers (the Cass-Ko opmans-Ramsey model).3. Issues raised by demographics, including the impact of public debt(primarily Diamond 1965).4. The implications of viewing growth and technological advance as en-dogenous processes, driven by market incentives (for example, P. Romer1990).Throughout, I will feature mathematical “detours” to develop tools andsolution methods useful in the application at hand, but also essential tofurther macroeconomic applications.Growth Theory: Some Salient FactsWith the Great Depression of the interwar period over, post-World WarII economists began to think about how national incomes were determined1over the long term by capital accumulation and technological progress. In thisregard the …rst widely in‡uential model was that of Solow (1956). Chapter 1of David Romer’s textbook is required reading for this section of 202A; also,you might glance at Solow’s original article on JSTOR.1Throughout our discussion of growth theories we will ask whether theycan help us understand the main features of the global economic landscape,so I present some salient facts at the outset.First of all, and most obviously, there are huge di¤erences in output percapita among countries. (See the following table.) Are these caused by dif-ferences in factor endowments? In technology? Something else? This isperhaps the most pressing single question in growth theory –and in devel-opment economics.The time series data on income per capita re‡ect that growth rates ofper capita income have di¤ered widely over time. Growth theory also seeksto understand why this is so. A key questions is whether countries that arerelatively poor will tend to grow more quickly than their richer neighbors,which might even allow them eventually to catch up. Countries in East Asialike China and Taiwan may be doing this, and indeed, some have recently“graduated”to high-income status. Others (such as many sub-Saharan coun-tries) show no evidence of catch-up: if anything, their relative position hasworsened over time. The following chart and graph show that there is no uni-versal tendency toward (unconditional) convergence in per capita incomes;some countries seem to be converging, but many others have diverged. Wewant to understand the factors behind this di¤erence.Assumptions of the Solow ModelFirst, let’s consider technology. The fundamental concept in the model isthe production function,Y = F (K; AL);where Y is total output (GDP), K is the capital stock, L is the labor forceemployed, and A represents a technological-knowledge coe¢ cient determin-ing the productivity of labor. An increase in either factor (or in A) raisesoutput. The production function exhibits constant returns to scale, meaningthat for any nonnegative constant ,F (K; AL) = F (K; AL):1A similar model written about the same time was by Trevor Swan, “Economic Growthand Capital Accumulation,”Economic Record 32 (November 1956): 334-61.2GDP per capita in year 2000 U.S. dollars Country 19602000 Average growth (% per year) Canada 10,577 26,821 2.4 France 8,605 25,045 2.7 Ireland 5,380 24,948 3.9 Italy 7,103 22,487 2.9 Japan 4,632 23,971 4.2 Spain 4,965 19,536 3.5 Sweden 10,955 25,232 2.1 United Kingdom 10,353 24,666 2.2 United States 13,030 34,365 2.5 Ghana 372 1,392 3.4 Kenya 1,159 1,268 0.2 Nigeria 1,096 1,074 -0.1 Senegal 1,797 1,571 -0.3 Zimbabwe 2,277 3,256 0.9 Argentina 7,859 11,332 0.9 Brazil 2,670 7,194 2.5 Chile 5,022 11,430 2.1 Colombia 2,806 6,080 2.0 Mexico 3,695 8,082 2.0 Paraguay 2,521 4,965 1.7 Peru 3,048 4,205 0.8 Venezuela 5,968 7,323 0.5 China 445 4,002 5.6 Hong Kong 3,264 27,236 5.4 Malaysia 1,829 11,406 4.7 Singapore 4,211 29,434 5.0 South Korea 1,544 15,702 6.0 Taiwan 1,491 19,184 6.6 Thailand 1,086 6,474 4.6Poor countries have not grown faster: growth rates relative to per capita GDP in 1960De…ne the capital stock per e¤ective worker ask  K=AL:Then, de…ne output per e¤ective worker asy  Y =AL =1ALF (K; AL) = F (k; 1)  f (k):Notice that because F (K; AL) = ALf(K=AL); then by the chain rule,@F (K; AL)@K= ALf0(k)1AL= f0(k);meaning that f0(k) is the marginal product of capital (MP K). This alsoimplies that the MP K depends only on the ratio of capital to e¤ective labor.We assume the concavity property that f00(k) < 0 (diminishing returns tocapital deepening).A property of constant returns production functions is that2Y =@F (K; AL)@KK +@F (K; AL)@(AL)AL: