THE ECONOMICS OF GROWTH Philippe Aghion and Peter Howitt with the collaboration of Leonardo Bursztyn The MIT Press Cambridge, Massachusetts London, England © 2009 Massachusetts Institute of Technology All rights reserved. No part of this book may be reproduced in any form by any electronic or mechanical means (including photocopying, recording, or information storage and retrieval) without permission in writing from the publisher. For information about special quantity discounts, please email [email protected] This book was set in Times Roman by SNP Best-set Typesetter Ltd., Hong Kong. Printed and bound in the United States of America. Library of Congress Cataloging-in-Publication Data Aghion, Philippe. The economics of growth / Philippe Aghion and Peter W. Howitt. p. cm. Includes bibliographical references and index. ISBN 978-0-262-01263-8 (hardcover : alk. paper) 1. Economic development. I. Howitt, Peter. II. Title. HD82.A5452 2009 338.9—dc22 2008029818 10 9 8 7 6 5 4 3 2 1 Contents Preface xvii Why This Book? xvii For Whom? xviii Outline of the Book xix Acknowledgments xxi Introduction 1 I.1 Why Study Economic Growth? 1 I.2 Some Facts and Puzzles 1 I.2.1 Growth and Poverty Reduction 1 I.2.2 Convergence 2 I.2.3 Growth and Inequality 4 I.2.4 The Transition from Stagnation to Growth 5 I.2.5 Finance and Growth 5 I.3 Growth Policies 6 I.3.1 Competition and Entry 7 I.3.2 Education and Distance to Frontier 8 I.3.3 Macroeconomic Policy and Growth 10 I.3.4 Trade and Growth 10 I.3.5 Democracy and Growth 11 I.4 Four Growth Paradigms 12 I.4.1 The Neoclassical Growth Model 12 I.4.2 The AK Model 13 I.4.3 The Product-Variety Model 14 I.4.4 The Schumpeterian Model 15 PART I: BASIC PARADIGMS OF GROWTH THEORY 19 1 Neoclassical Growth Theory 21 1.1 Introduction 21 1.2 The Solow-Swan Model 21 1.2.1 Population Growth 24 1.2.2 Exogenous Technological Change 27 1.2.3 Conditional Convergence 29 1.3 Extension: The Cass-Koopmans-Ramsey Model 31 1.3.1 No Technological Progress 31 viii Contents 1.3.2 Exogenous Technological Change 37 1.4 Conclusion 39 1.5 Literature Notes 39 Appendix 1A: Steady State and Convergence in the Cass-Koopmans-Ramsey Model 40 Appendix 1B: Dynamic Optimization Using the Hamiltonian 43 Problems 45 2 The AK Model 47 2.1 Introduction 47 2.1.1 The Harrod-Domar Model 48 2.2 A Neoclassical Version of Harrod-Domar 49 2.2.1 Basic Setup 49 2.2.2 Three Cases 51 2.3 An AK Model with Intertemporal Utility Maximization 52 2.3.1 The Setup 53 2.3.2 Long-Run Growth 54 2.3.3 Welfare 55 2.3.4 Concluding Remarks 55 2.4 The Debate between Neoclassical and AK Advocates, in a Nutshell 56 2.5 An Open-Economy AK Model with Convergence 60 2.5.1 A Two-Sector Closed Economy 61 2.5.2 Opening up the Economy with Fixed Terms of Trade 62 2.5.3 Closing the Model with a Two-Country Analysis 64 2.5.4 Concluding Comment 66 2.6 Conclusion 66 2.7 Literature Notes 67 Problems 67 3 Product Variety 69 3.1 Introduction 69 3.2 Endogenizing Technological Change 69 3.2.1 A Simple Variant of the Product-Variety Model 70 3.2.2 The Romer Model with Labor as R&D Input 74 3.3 From Theory to Evidence 77 3.3.1 Estimating the Effect of Variety on Productivity 77 Contents ix 3.3.2 The Importance of Exit in the Growth Process 79 3.4 Conclusion 80 3.5 Literature Notes 81 Problems 82 4 The Schumpeterian Model 85 4.1 Introduction 85 4.2 A One-Sector Model 85 4.2.1 The Basics 85 4.2.2 Production and Profi ts 86 4.2.3 Innovation 87 4.2.4 Research Arbitrage 88 4.2.5 Growth 89 4.2.6 A Variant with Nondrastic Innovations 90 4.2.7 Comparative Statics 91 4.3 A Multisector Model 92 4.3.1 Production and Profi t 92 4.3.2 Innovation and Research Arbitrage 94 4.3.3 Growth 95 4.4 Scale Effects 96 4.5 Conclusion 99 4.6 Literature Notes 100 Problems 101 5 Capital, Innovation, and Growth Accounting 105 5.1 Introduction 105 5.2 Measuring the Growth of Total Factor Productivity 106 5.2.1 Empirical Results 107 5.3 Some Problems with Growth Accounting 109 5.3.1 Problems in Measuring Capital, and the Tyranny of Numbers 109 5.3.2 Accounting versus Causation 112 5.4 Capital Accumulation and Innovation 113 5.4.1 The Basics 114 5.4.2 Innovation and Growth 116 5.4.3 Steady-State Capital and Growth 116 5.4.4 Implications for Growth Accounting 118 x Contents 5.5 Conclusion 119 5.6 Literature Notes 119 Appendix: Transitional Dynamics 120 Problems 121 PART II: UNDERSTANDING THE GROWTH PROCESS 127 6 Finance and Growth 129 6.1 Introduction 129 6.2 Innovation and Growth with Financial Constraints 130 6.2.1 Basic Setup 130 6.2.2 Innovation Technology and Growth without Credit Constraint 132 6.2.3 Credit Constraints: A Model with Ex Ante Screening 132 6.2.4 A Model with Ex Post Monitoring and Moral Hazard 134 6.3 Credit Constraints, Wealth Inequality, and Growth 136 6.3.1 Diminishing Marginal Product of Capital 136 6.3.2 Productivity Differences 139 6.4 The Empirical Findings: Levine’s Survey, in a Nutshell 142 6.4.1 Cross-Country 143 6.4.2 Cross-Industry 145 6.5 Conclusion 147 6.6 Literature Notes 147 Problems 148 7 Technology Transfer and Cross-Country Convergence 151 7.1 Introduction 151 7.2 A Model of Club Convergence 152 7.2.1 Basics 152 7.2.2 Innovation 153 7.2.3 Productivity and Distance to Frontier 154 7.2.4 Convergence and Divergence 156 7.3 Credit Constraints as a Source of Divergence 158 7.3.1 Theory 159 7.3.2 Evidence 161 7.4 Conclusion 163 7.5 Literature Notes 165 Problems 166 Contents xi 8 Market Size and Directed Technical Change 169 8.1 Introduction 169 8.2 Market Size in Drugs 169 8.2.1 Theory 169 8.2.2 Evidence 171 8.3 Wage Inequality 173 8.3.1 The Debate 174 8.3.2 The Market-Size Explanation 176 8.4 Appropriate Technology and Productivity Differences 182 8.4.1 Basic Setup 182 8.4.2 Equilibrium Output and Profi ts 183 8.4.3 Skill-Biased Technical Change 184 8.4.4 Explaining Cross-Country Productivity Differences 185 8.5 Conclusion 186 8.6 Literature Notes 187 Problems 188 9 General-Purpose Technologies 193 9.1 Introduction 193 9.2 Explaining Productivity Slowdowns 196 9.2.1 General-Purpose Technologies in the Neoclassical Model 196 9.2.2 Schumpeterian Waves 198 9.3 GPT and Wage Inequality 204 9.3.1 Explaining the Increase in the Skill Premium 204 9.3.2 Explaining the Increase in Within-Group Inequality 206 9.4 Conclusion 210 9.5 Literature Notes 211 Problems 212 10 Stages of Growth 217 10.1 Introduction 217 10.2 From Stagnation to Growth 217 10.2.1 Malthusian Stagnation 217 10.2.2 The Transition to Growth 222 10.2.3 Commentary 224 10.3 From Capital Accumulation to Innovation 226 10.3.1 Human-Capital Accumulation 226 xii Contents 10.3.2 Physical-Capital Accumulation 227 10.4 From Manufacturing to Services 230 10.5 Conclusion 232 10.6 Literature Notes 232 Problems 233 11 Institutions and Nonconvergence Traps 237 11.1 Introduction 237 11.2 Do Institutions Matter? 238 11.2.1 Legal Origins 239 11.2.2 Colonial Origins 240 11.3 Appropriate Institutions and Nonconvergence Traps 243 11.3.1 Some Motivating Facts 243 11.3.2 A Simple Model of Distance to Frontier and Appropriate Institutions 246 11.4 Conclusion 258 11.5 Literature Notes 261 Problems 263 PART III: GROWTH POLICY 265 12 Fostering Competition and Entry 267 12.1 Introduction 267 12.2 From Leapfrogging to Step-by-Step Technological Progress 267 12.2.1 Basic Environment 268 12.2.2 Technology and Innovation 269 12.2.3 Equilibrium Profi ts and Competition in Level and Unlevel Sectors 269 12.2.4 The Schumpeterian and “Escape-Competition” Effects 271 12.2.5 Composition Effect and the Inverted U 272 12.2.6 Empirical Evidence 274 12.3 Entry 274 12.3.1 The Environment 276 12.3.2 Technology and Entry 276 12.3.3 Equilibrium Innovation Investments 277 12.3.4 The Effect of Labor Market Regulations 278 12.3.5 Main Theoretical Predictions 279 Contents xiii 12.3.6 Evidence on the Growth Effects of Entry 279 12.3.7 Evidence on the Effects of (De)Regulating Entry 280 12.4 Conclusion 281 12.5 Literature Notes 282 Problems 283 13 Investing in Education 287 13.1 Introduction 287 13.2 The Capital Accumulation Approach 288 13.2.1 Back to Mankiw, Romer, and Weil 288 13.2.2 Lucas 292 13.2.3 Threshold Effects and Low-Development Traps 295 13.3 Nelson and Phelps and the Schumpeterian Approach 297 13.3.1 The Nelson and Phelps Approach 297 13.3.2 Low-Development Traps Caused by the Complementarity between R&D and Education Investments 300 13.4 Schumpeter Meets Gerschenkron 302 13.4.1 A Model of Distance to Frontier and the Composition of Education Spending 302 13.4.2 Cross-Country and Cross-U.S.-State Evidence 307 13.5 Conclusion 311 13.6 Literature Notes 312 Problems 314 14 Reducing Volatility and Risk 319 14.1 Introduction 319 14.2 The AK Approach 321 14.2.1 The Jones, Manuelli, and Stacchetti Model 321 14.2.2 Counterfactuals 324 14.3 Short-versus Long-Term Investments 326 14.3.1 The Argument 326 14.3.2 Motivating Evidence 327 14.3.3 The AABM Model 329 14.3.4 Confronting the Credit Constraints Story with Evidence 339 14.3.5 An Alternative Explanation for the Procyclicality of R&D 340 14.4 Risk Diversifi cation, Financial Development, and Growth 341 14.4.1 Basic Framework 341