Innovations in Macroeconomics Paul J.J. Welfens Innovations in Macroeconomics ThirdEdition 2123 Prof.Dr.PaulJ.J.Welfens EIIW–EuropeanInstituteforInternational EconomicRelations attheUniversityofWuppertal Rainer-Gruenter-Str.21 42119Wuppertal Germany and SciencesPo,Paris 27,RueSt.Guillaume [email protected] ISBN978-3-642-11907-1 e-ISBN978-3-642-11909-5 DOI10.1007/978-3-642-11909-5 SpringerHeidelbergNewYorkDordrechtLondon LibraryofCongressControlNumber:2011934030 © Springer-VerlagBerlinHeidelberg2006,2008,2011 Thisworkissubjecttocopyright.Allrightsarereserved,whetherthewholeorpartofthematerialis concerned,specificallytherightsoftranslation,reprinting,reuseofillustrations,recitation,broadcasting, reproductiononmicrofilmorinanyotherway,andstorageindatabanks.Duplicationofthispublication orpartsthereofispermittedonlyundertheprovisionsoftheGermanCopyrightLawofSeptember9, 1965,initscurrentversion,andpermissionforusemustalwaysbeobtainedfromSpringer.Violations areliabletoprosecutionundertheGermanCopyrightLaw. Theuseofgeneraldescriptivenames,registerednames,trademarks,etc.inthispublicationdoesnotimply, evenintheabsenceofaspecificstatement,thatsuchnamesareexemptfromtherelevantprotectivelaws andregulationsandthereforefreeforgeneraluse. Coverdesign:estudiocalamar,Berlin/Figueres SpringerispartofSpringerScience+BusinessMedia(www.springer.com) Preface to the Third Edition Itiscertainlyunusualtohaveabookinitsthirdeditionwithinfouryears—Ihope that this testifies to the growing interest in innovation dynamics on the one hand andontheotherhandinfindingbetterwaysformacroeconomicmodeling. Ihave benefitedfromencouragementfromDavidAudretschandseveralothercolleagues; this particularly refers to the cooperation in a Jean Monnet Project where I have enjoyed fruitful discussions with Cillian Ryan andAndrew Mullineux, University of Birmingham.As regards the new chapter on theTransatlantic Financial Market Crisis I am also indebted to discussions with Werner Roeger and Jürgen Kröger, EuropeanCommission, CarolineFohlin, JohnsHopkinsUniversity, Baltimoreand WalterEubanks,CongressionalResearchService,WashingtonDC;theauthoralso appreciatesthedebateattheGlobalJeanMonnetConference/ECSA-WorldConfer- ence2008“AEuropeofAchievementsinaChangingWorld”;Brussels,November 24-25,2008.IamalsogratefulfortechnicalsupportbyMichaelAgner,Universityof OdenseandMevludIslamiaswellasJensPerret,EIIW/SchumpeterSchoolofBusi- nessandEconomicsattheUniversityofWuppertal.Thenewmedium-termhybrid macromodelpresentedinthefirsteditionseemstobeparticularlyusefulinunder- standing the effects of the international banking crisis: Output is determined—via a modified version of Friedman’s permanent income consumption hypothesis—by bothshort-termaggregatedemandandbytheanticipatedlong-run(steadystate)in- comeasderivedfromtheneoclassicalgrowthmodel.Ihavealsoincludedachapter onfinancialinnovationsinthisenlargededition.Thereadersinterestedinabroader analysisoftheinternationalbankingcrisisareinvitedtotakeacloserlookatthebook TransatlanticBankingCrisisandSovereignDebtDynamics.ExplainingaModern DisasteroftheWestissuggested,buttheofferedreflectionsonlygiveanewstarting pointinthisfield.Theinstitutionalinnovationssuggestedhereandpresentedatthe CongressionalResearchService,theEuropeanCommission,theUniversityofEco- nomicsandFinance,St.Petersburg,andtheJohnsHopkinsUniversity,Baltimore,in 2009arepartandparcelofinnovativeinstitutionalreformsthatseemtobenecessary inaworldeconomywithpotentiallyunstableglobalizationdynamics.Lastbutnot least, I am also grateful to the institutional network at the Schumpeter School of BusinessandEconomicsattheUniversityofWuppertal. v vi PrefacetotheThirdEdition OneofthefinalchapterslookintoareformulationoftheMarshall-Lernercon- dition for a world with foreign direct investment and comes up—compared to the standardapproach—withratherdifferentresultsforsomeparameterconstellations. AsforeigndirectinvestmentcontinuestogrowrelativetoGDPinmanycountries, one should carefully consider the implications, namely that real depreciations of currencieswilloftenonlycontributetoachangeinthecurrentaccountpositionto alimitedextent;thisisapointthathasbeenemphasizedtimeandagainbyRonald McKinnon(thespecificpointswhichIsuggestare,however,somewhatdifferentto the well-known arguments of McKinnon). Moreover, new approaches to optimum growth and for the link between trade, FDI and output are developed. Finally, the role of a hybrid macroeconomic model for the understanding of banking crisis is emphasized—andnewinsightsintomodifiedneoclassicalgrowthmodelsofclosed andopeneconomiesareconsidered(withdueemphasisoninnovationdynamicsand R&DemploymentaswellasaspectsoftheCES-function). Thosewhoconsidermarketeconomyanddemocracyastwocrucialelementsfor adecentlifecannotavoidtofranklydiscussthestrangedevelopmentsoffinancial globalizationandtopushforconsistentreforms.Theresponsibilityfortheanalysis isallmine. December2010 Prof.Dr.PaulJ.J.Welfens WuppertalandParis Preface to the Second Edition Withinoneyear,thisbookhasalreadybeenpublishedinasecondedition,testifying tothebroadinterestintheimportantsubjectscovered.Ihavemadesomeclarifica- tionsandalsosomecorrections,whilealsoaddinganewchapteronInnovationsand theEconomicsofExhaustibleResources,animportantfieldwithrespecttothelink betweenmodernSchumpeterianinnovationanalysisandmacroeconomics.InChap. G, there are additional reflections on the ambiguity of the traditional approach of optimumgrowththeoryaswellwithkeyinsightsdrawingonmyKondratieffPrize Lecture in Moscow in 2007. I have also added some new ideas on the Macroeco- nomics of Microeconomics which basically argues that there should be a double consistencyinEconomics. Thebasicperspectiveofthisbookistoemphasizetheneedtoconsidertheinnova- tionphenomenoninabroaderperspective;itisnotonlyrelevantforcertaincyclical dynamics but also—in a more traditional vein—for long term growth analysis as wellassustainableeconomicdevelopment. I have particularly benefited from my visiting Alfred Grosser professorship 2007/2008 at Sciences Po, Paris, and the interesting discussions with Antoine Leblois,Paris,andthesuggestionsofGerhardHuhn,MevludIslamiandJensPerret, EIIW Wuppertal. Finally, I am grateful to discussions with my colleagues in the JeanMonnetProjectFinancialMarketIntegration, StructuralChange, ForeignDi- rectInvestmentandEconomicGrowthinEU25.IamparticularlygratefultoJulius HorvathattheCentralEuropeanUniversity,Budapest. Mygreatestgratitudegoestomywonderfulfamilywhohassupportedmyresearch withsomuchpatienceoversomanyyears. December2008 Prof.Dr.PaulJ.J.Welfens WuppertalandParis vii Preface to the First Edition This book deals with the role of innovations in macroeconomics, and it presents innovationsinmacroeconomictheory.Growthandstructuralchangearekeyissues here,butwealsotouchuponlinksbetweenexchangeratedynamicsandinnovations. The approaches and ideas presented are not integrated into a large comprehensive model. Rather, we present analytical building blocks in selected fields of Schum- peterianMacroeconomics,includingnewinsightsabouttrade,growth,exchangerate dynamics,innovationsandpolicyoptions. An important starting point in Chap.A is a generalization of the Solow growth model and a long term analysis of the link between process innovations and the pricelevelaswellastheexchangerate,whichisshowntocriticallydependonthe income elasticity of the demand for money. Moreover, we discuss the long term Phillips curve in the context of a growth model and can thereby gain some new insights. The theoretical reflections presented suggest the need for new empirical work.Wealsoconsidertheroleofforeigndirectinvestmentflows.ChapterBisan attempttobridgethemediumtermanalysiswiththelongrungrowthanalysis.Itis arguedthatindividualswillpartlybaseconsumption—andthussavings—oncurrent income and expected steady state income. While this approach is closely related tothepermanentincomehypothesis, itsspecificimplicationsarequiteinteresting. ChapterCtakesacloserlookatsomeintegrationissues. ChapterDputsthefocus onbothgrowthinopeneconomiesandtherealexchangerate.TheanalysisinChap. Eisagaindevotedtoopeneconomytopics,wherewepresentaMundell-Fleming- Schumpetermodelwithproductinnovations. Chap. Ffocusesonthelinkbetween stockmarketdynamicsandtheexchangerate,andtheframeworkpresentedisnew andworksrathersatisfactorilyfromanempiricalperspective.ChapterGstartswith thetraditionaloptimumgrowthframeworkandthenproceedsbylookingatthetopic of endogenous growth (or quasi-endogenous growth). Chapter H involves trade, structuralchangeandgrowthinopeneconomies,whileChap.Ilooksattheroleof innovationsinadigitalmarketeconomy.ChapterJputsthefocusonEUinnovation policy and raises some critical questions about the EU economic policy. Finally, Chap.Kconsiderssomeaspectsofmonetaryintegrationandgrowthincludingbasic policyimplications.Inarathersimpleapproach,weexplainwhytheintegrationof globalfinancialmarketshasbroughtaboutaglobalfalloftheinterestratealongwith ix x PrefacetotheFirstEdition ahigherstockmarketpriceindex. Essentially, thereisaninterplaybetweenAsian capital inflows into the US and an increasing international bonds substitutability concerningDollar-denominatedandEuro-denominatedassets(thestartoftheEuro hascreatedaEuropeanbondsmarketwhicheffectivelyoffersbettersubstitutestothe DollarbondsthanwasthecaseforthepreviousDM-$comparison).Wealsolookat someothermonetaryissues.Asregardsthelinkbetweeneconomicpolicymeasures andeconomicdevelopment, oneshouldemphasizethatpolicymakersrarelymake thecrucialdistinctionbetweenchangesinthelevelofthegrowthpathandthegrowth rateitself.Thisdistinctionisquiteimportantinthecontextofthebasicandmodified neoclassicalgrowthmodel. Possiblythemostimportantshiftofanalyticalemphasisistheideathatoneshould takealookatvariousmodelingapproacheswherebythechoiceofmodeldepends on the time horizon and the specific initial situation. From a policy perspective medium term models could be quite useful, however there is no adequate model whichbridgestheshortrunandthelongrun. Oneofthenewideaspresentedhere istolinktheshorttermandlongrunaspectsinanewmediumtermKeynes-Solow model.Inthisapproach,itisemphasizedthatbothaggregatedemandandaggregate supplydeterminethedynamicsofactualincome.Inamediumtermperspective,this approachcanalsobeappliedtohybridgrowthmodeling;inrealitythereisrarelya caseforwhichonlythedemandsideoronlythesupplysideisvalid. Someoftheanalyticalelementspresentedarerefinementsorextensionsofexisting approaches; other contributions aim at clarifying apparent inconsistencies in the literature.Animportantaspecthereistheinconsistency,implyingforinstancethat PolandorChinaexportmainlycapitalgoodstotheUSAandEU15,whilerealityis characterizedbytradeflowsofmachineryandequipmentintheoppositedirection betweenneoclassicalgrowththeoryandneoclassical(Heckscher-Ohlin-Samuelson) tradetheory.Economicsisascientificfieldinwhichcompetitionamongresearchers stimulatesthespecializationofscientistsaswellastheexplorationofnarrowislands. Littleresearchisdevotedtobuildingintellectualbridgesbetweenislandsinorderto analyzethecombinedinsightsortocombinepossiblevariantsofmodelsdeveloped oneachisland.Afewbridgesarepresentedhere. In market economies, innovation dynamics have played a crucial role since the IndustrialRevolution.SchumpeterianEconomicshasanalyzedsomeofthesedevel- opmentsonthebasisofanevolutionaryapproachwhichisusefulinmanyfields.At theotherendofthespectrum,thereareinnovationresearcherswhopersuearather narrow focus on invention and novel products or on new process technologies in certainsectors.Thisisunsatisfactoryinthesensethatinnovationdynamicsshould becombinedwithmacroeconomicanalysis, includinggrowthanalysisandmodels of stabilization policy. The new growth theory has delivered some interesting re- sults including aspects related to product differentiation and spillover effects. In a differentcontext,realbusinesscyclemodelshaveshownthattechnologicalchanges are able to generate economic cycles in a quasi-Walrasian world with no frictions in markets. However, the latter is a contradiction in itself since every innovation automatically creates information asymmetries which, in turn, take us away from competitivemarketclearing. PrefacetotheFirstEdition xi Fromaninputperspective,onecanmeasureinnovationdynamicstosomeextent using the ratio of expenditures on research and development (R&D) to Gross Do- mesticProductorR&Dexpenditurespercapita,fromanoutputperspectivethrough the number of (international) patents or patent applications per capita. In the sec- ond half of the twentieth century, the R&D-GDP ratio increased continuously in OECDcountriesasdidthenumberofpatentapplicationspercapita.Atthestartof thetwenty-firstcenturytheR&D-GDPratiointheleadingOECDcountry,Sweden, reached 4%, in Japan 3%, and in the US and the EU15 it was close to 2.5%, up fromabout1%intheearly1960s.Itisnotonlyimpressivetoobservehowstrongly R&Dexpenditureshaveincreased,butonemustalsoconsidertheR&D-GDPratioin comparisonwiththeinvestment-GDPratio,whichisaround20%inleadingOECD countries.As much as investment in machinery and equipment is the basis for the accumulationofaphysicalcapitalstock,thestreamofR&Dexpendituresamounts to the accumulation of an R&D stock, which obviously contributes to the output of individual firms and the overall economy. Patent applications also increased in OECDcountriesinthe1980sand1990s.However,manyinnovationscannoteasily bepatented;softwareisadifficultfieldinthisrespect. Patenting behavior can also change considerably as market structures change. Withrespecttothis,thecaseofliberalizationinEuropeanfixed-linetelecommuni- cations is interesting. Apparently, privatized former state-owned monopolies have intensifiedpatentingwhichisnaturalinanenvironmentthathasbecomemorecom- petitive and more internationalized. (At the same time it seems that innovation activities have shifted away from network operators to the equipment industry.) Changesinpatentingbehaviormakeinterpretationofgrowthinpatentapplications ratherdifficult. Theresultsofinnovationeffortsarenotsimplypatents,butwhatmattersmostare twotypesofinnovations: (cid:129) Processinnovationswhichimplycuttingcostsandthusbringingaboutahigher equilibrium output in markets; even modeling the simple case of endogenous technological progress in the context of a macroeconomic production function is not easy. Special problems occur if the industry has static or dynamic scale economies,afieldnotanalyzedmuchinthisbook. (cid:129) Product innovations increase the willingness to pay on the demand side. This is a field of particular interest here, specifically in the case of open economies. Schumpeterian competition—based on product innovations—in a two-country modelnolongerallowsfortheassumptionthatthelawofonepricewillhold. AsdiscussedinIndustrialEconomicsliterature,existinginnovation-relatedliterature ineconomicsisdividedontheonehandintoinnovationanalysis.Ontheotherhand, there is a niche in macroeconomic analysis, with some strands in the new growth literaturelookingintoprocessinnovationsincludingtechnologyspillovers.Thisis done,forexample,inmodelsbyROMERandLUCAS.GROSSMAN/HELPMAN have emphasized the role of product differentiation and hence product innovation broadlydefined.However,thosearerareeffortswhichindeedconcernonlypartof macroeconomicanalysis.Thisbookseekstoaddsomebuildingblockstotheexisting